The Beauty of Combinational Strategies

I have written about all the main option strategies and many of those articles have been about combinational strategies – trades involving two or more options simultaneously.

The reason I’ve sought to bring your attention to the various strategies is to show how each strategy is such a unique tool. Much like hydrogen and oxygen combine to form a unique substance (water), putting options together into various combinations results in some amazingly unique risk/reward profiles.

For example, the sale of a naked at-the-money option is a very risky strategy. And the purchase of an out-of-the-money option is costly and has a poor probability of success. However, do both of these trades together and (provided the two options are of the same type and in the same expiration month) you form a credit spread – one of the safest and most successful strategies there is.

Buy an at-the-money call or a put and the chances are good that you will loose all your money (stops notwithstanding). However, buy a straddle (both a call and a put at the same strike price and expiration month) and the possibility of losing all your money is practically nil(the underlying would have to finish precisely on the strike price).

Note that no strategy automatically makes money. I once thought that there might be a magical combination that would allow me to consistently produce positive returns. It took a while but I finally realized that, since each (fairly valued) option is a net zero expected return item, you still have a net zero expected return no matter how many you put together.

Any combination of fairly valued options is a fairly valued combination. By definition, “ fair valued” means there is no advantage to either the buyer or seller. To make money, you must either have a model that says the options are currently mispriced (which happens pretty often) or have a directional prediction that comes true. Note that the directional prediction might be complicated. For example, “the stock will either break out strongly to the upside or drift lower”. (Can you remember the best strategy for this kind of prediction? That’s right, a call backspread.)

Since no particular strategy is always the correct one the trader needs to be able to apply the best strategy in any given situation. This requires familiarity withthe various strategies and how they perform. Tables and diagrams have been constructed to show which option strategies are bullish, bearish, aggressive, moderate, or neutral.

While those kinds of tables and diagrams can be somewhat useful, many strategies overlap with other strategies in their applicability. They also tend to not take into account all three primary considerations: price direction, time frame, and volatility. So a feel for how the various strategies perform is best gained through experience. Fortunately, that process may be accelerated by using software that simulates the performance of any given strategy in all three dimensions.

By the way, when I say options are mispriced fairly often, I am mostly referring to the concept that all the options of a given asset are sometimes too expensive, or too cheap – not so much to the idea that one individual option is mispriced. It is rare that one individual option is mispriced, and if it happens, it would probably be so short-lived that you would never catch it.

It is easy to find situations when all the options of an asset are collectively expensive or cheap. Buying cheap options and/or selling expensive options is called “volatility trading”. I have written a lot about this reliable approach to options trading. This approach requires sophisticated tools, and naturally I recommend that all options traders use software to assist them in decision-making and recordkeeping.

Many people who know about options but are not truly familiar with them believe that options are inherently risky. While options allow you, and even tempt you, to take speculative risk, it is not true that options are inherently risky. Options are enormously flexible in the ways you can use them, not only to speculate, but also to hedge or even simulate a portfolio, and through combinational strategies, construct a position that closely fits your goals, price predictions, time frame, and the current volatility environment.

Len Yates is the President and founder of OptionVue Systems International and has earned worldwide recognition for his groundbreaking work in options analysis software. He has published numerous books and articles on options analysis and trading strategies, and is a primary contributor for the educational site DiscoverOptions.com