When to use combination trades

optionMONSTER

There are really only four basic things that can be done in the options world: A trader can buy or sell a call or a put. All of the complex option positions out there with the funny names are simply combinations of the above.

One thing to keep in mind is that end strategies can almost always be made with different combinations.

I was reminded of this fact on several occasions in recent days. The first came from a calendar spread in EMC recently , when a trader bought 5,600 January 2014 30 puts and sold  the January 2013 30 puts for a net of $2.09. I wrote up the trade and was later hit with emails asking about my "mistake."

As it turns out, the trade was broken and replaced with a call calendar in which the trader bought 5,600 January 2014 30 calls and sold the 2013 calls for a bet debit of $2.09. So there was some confusion on the part of anyone who read what I wrote about puts and saw the volume in the calls.

But the important thing is that it is essentially the exact same trade. A put calendar and a call calendar done at the same strike for the same price is the same strategy.
 
The second example came from a Barron's column on a Goldman Sachs study that showed that "strangling" stocks outperforms owning them. The column starts by stating: "The strategy of selling a call on a stock beats classic buy-and-hold investing, but a modest alteration to the strategy can produce even better results."

What this is obviously alluding to is the covered cal l. Indeed, studies have shown that covered calls outperform buy-and-hold strategies in the long term, except in strong bull markets.

The column goes on to discuss short strangles , in which out-of-the-money calls and puts are sold to collect the option premium. What is unclear from the article is whether the recommendation is to do so against long stock, though that is what it appears to be saying.

Traditional strangles are done without stock, though most media outlets only discuss strangles against long shares because the latter strategy theoretically doesn't carry the unlimited risk of the former.

But selling strangles against long stock is simply adding short puts to covered calls. The trick is that they represent identical strategies. So it is no surprise that doubling your exposure, and therefore your risk, will increase your gains--when those strategies are working, that is. In the event of a market crash, the losses will be even greater.

It is quite true that options premiums are usually considered too high, but that doesn't mean it's a great idea to sell twice as many contracts. Just ask all of the funds and traders that have gone belly-up leveraging short-volatility positions.

(A version of this article appeared in optionMONSTER's Education Newsletter of Sept. 19.)

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