Day70. Financial term | Combination options

Combination options are an advanced option trading strategy that involves combining multiple option contracts to construct a portfolio with specific risk and return objectives. This strategy can be used for risk hedging, increasing returns, or seeking investment opportunities under specific market conditions.

In simple terms, combination options involve strategically combining option contracts to achieve investment goals in various market scenarios.

Common combination options strategies typically include:

1. Protective Put: Investors simultaneously hold stocks and a corresponding quantity of put options to protect their stock investment from price declines.

2. Covered Call: Investors hold stocks while selling call options, primarily to reduce the risk for stockholders and generate additional premium income in neutral or cautiously bullish market expectations.

3. Naked Put: Investors sell put options, expecting stock prices to rise or remain stable, and generate income from option premiums.

4. Vertical Spread: Investors simultaneously buy and sell option contracts of the same type with different strike prices but the same expiration date. The primary purpose is to achieve investment goals under specific market expectations by limiting potential losses and reducing initial investment costs.

5. Straddle: Investors simultaneously buy and sell call and put options with the same expiration date and strike price. This strategy is often used for risk hedging, especially in uncertain market trends.

Take the covered call strategy as an example:

Suppose Jack holds shares of Company A, with the current stock price at $100 per share. He anticipates that Company A's stock is unlikely to experience significant increases or decreases in the near future. To generate additional income, he chooses to use the covered call option strategy.

The specific details are as follows:

1. Jack holds 1,000 shares of Company A's stock, with a total value of $100,000.

2. Jack sells a corresponding number of call options on Company A, with a strike price of $110 and an expiration date three months from now.

3. The premium for the call option is $10 per contract.

In this case, Jack generates premium income by selling call options as supplemental income to holding the stock.

If Company A's stock price is below $110 at the option's expiration, the call options will not be exercised, and Jack continues to hold the stock, keeping the premium as additional income. If Company A's stock price is above $110 at option expiration, the call options may be exercised, and Jack would need to sell the stock at the strike price. However, he still benefits from the income generated from the premium, which mitigates potential losses to some extent.

This is a simplified example, and in practice, you need to consider factors such as stock price trends, option expiration dates, strike prices, and market volatility when formulating strategies.

Given the complexity and risks of combination option strategies, novice investors should approach the market with caution and consider using combination option strategies only after gaining a solid understanding of the basic concepts and risks of the option market.

Additionally, seeking advice from professional financial advisors or experienced traders is recommended to ensure a better understanding and application of combination option strategies.