Combination Strategies

A number of combination strategies can be developed by combining call and put options
with equity shares. Some of these are discussed below:
(a) Neutralising the risk of a long position on in a share
(b)
(c)
(d)
(e)
(f) : A long position gets created when the shares are bought with the intention of
selling them at a future date at higher prices. However in such a case the risk is
that there may be a fall in the price of the share if the expectation does not turn
out to be true. The risk of such an open position can be taken care of by
purchasing a put option at or almost the same exercise price at which the shares
have been bought
(g)
(h) e.g., A single share is purchased at a price of Rs. 100 and at the same time a put
option is also purchased at the price of Rs. 100. Let us now see what will be the
total worth of our portfolio on the expiry date of the option contract assuming the
share price on expiry is (a) 40, (b) 100 & (c) 150. (Ignoring Premium)

1. Ending Value of Put

2. Option Exercised

Possibility A

Possibility B

Possibility C

100 40 = +60
Yes, got Rs.100

100 100 = 0
No

100150 = -50
No, ending
value is negative

3. Share Price on Expiry

40
100
4. Total Portfolios worth
Same as it was at
Again Same
(for both positions)
the time of entering
the deal

150
Higher

Note : Ending Value of Put shall be Agreed price - Stocks ending price x No. of shares.
e.g.,: Let the current price of share which Mr. Z holds be Rs. 50. Mr. Z buys a put and
writes/sells a call option simultaneously, both at an agreed price of Rs. 60. For simplicity
assume the share can take either of the two values on expiry i.e., Rs. 80 & Rs. 40.
Determine his gain or loss (excl premium)
Total Worth of the Portfolio
Possibility I
1. Maturity Price of the Share
Rs.80
2. Ending Value of Put Option
60-80 = -20
3. Whether Put Option is Exercised No
4. Ending Value of Call Option
60-80 = -20*
5. Whether Call Option gets Exercised Yes

Possibility II
Rs.40
60- 40 = + 20
Yes
40- 60 = - 20
No

Total Portfolios worth/PROFIT to buyer

Rs.20

Rs.-20

Note*:Since Mr. Z has written the call option, he would stand to be a loser to the extend
of Rs.20. Also the loss can only be Rs 20 as at expiry there can be only one possibility .
QUESTION Then why someone writes calls , obviously the premium he/she gets say a
premium on Rs 10 each would compensate the loss fully

(2) Straddle :
Many a times an investor is not sure about the future direction of the stock which may be
due to any future event. E.g. a court decision on the Company may be forthcoming in a
months time and if the decision is in the favour of the Company it can be good for the
Company , however if the decision is not favorable then it can affect the stock adversely.
Similar may happen in decisions pertaining to mergers, acquisitions and even when there
is buy back of shares in some cases.
A Trading strategy must be developed in case of such situations to hedge the volatility in
the stock which is protection against sharp fluctuations in the price in both the directions.
This strategy is called Straddle and it is a long straddle ( where we simultaneously buy a
call and a put option) and a short straddle ( where we simultaneously sell a call and put
option) On most instances the exercise price ( say X) and the expiry price ( say T ) is the
same and the cost of straddle is C+P . The impact of the cost of straddle simply means
that on maturity the stock price must depart from X substantially ( either on positive or
negative side) to get clear profits. This is because the cost C+P must be met out of the
difference as given below
Value of the Straddle at Expiry (long straddle)
ST X
Payoff under Call
Payoff under put
TOTAL

ST< X

ST X
0
0
X -ST
---------------------------------------------ST X
X -ST

Thus the returns under a straddle are positive in both the cases, first when the stock
price is higher than exercise price on maturity/expiry of the period and second when the
exercise price is higher than the stock price on expiry.
The worst possible scenario would be X = S T on expiry; when the straddle buyer of e.g.
long straddle has to be satisfied with cost. Thus the basic objective of a straddle is to bet
on volatility and the investor must feel that the stock shall be more volatile than what it is
today and also more volatile than the market in general.
On the other hand the writer of straddle does not agree with the future volatility of
the stock and the writer of the straddle takes a position called short straddle. Short
straddle which is a mirror image of the long straddle has unlimited downsize risk

(3) Collars : This strategy is for those investors who want limited returns with limited
risks. This is explained as under :
A : 2000 shares of a stock are purchased @ Rs 100 per share = Rs 2,00,000
However the investor wants the risk to be limited to 10 % then the strategy shall be
1a . Buy a Put Option of 2000 shares @ Rs.90 (assuming available)
1b. Sell a Call Option of 2000 shares @ 110 (assuming available)
Now A + 1a Protects he investor against the downslide of the stock e.g. : If the
market price fall to Rs 60 , one loses Rs 80,000 ( see A Above) in our stock but one
gets back 60,000 ( see 1a above) from Put option making a net loss of Rs 20,000
Now A + 1b however restricts the upside of the investor e.g. : If the market price
rises to Rs 150 , one gains Rs 100,000 ( see A Above) in our stock but loses 80,000
( see 1b above) from call option making a net gain of Rs 20,000
NOTE : In case of A + 1a , call option is not exercised while in case of A + 1b , put
option is not exercised.
(4)Spread : A spread is the combination of either of the following :
(a) Two or more call options on the same stock but with different exercise price.
(b) Two or more put options on the same stock but with different exercise price.
(c) Two or more call options on the same stock but with different time to expiry
(d) Two or more put options on the same stock but with different time to expiry
(e) One call and one put option on the same stock but with different exercise price
( NOTE : Both the positions must be the same i.e. either put or call)
Also note : Strategy (a), (b) and (e) are called money spread while (c) and (d) are time
spread strategies