Short Combo
The Setup
Consider a scenario where you are bearish on ABC Corporation, currently trading at $100 per share. To implement a short combo, you might:
- Sell a call option with a strike price of $100, receiving a premium of $4 per share.
- Buy a put option with the same strike price of $100, paying a premium of $4 per share.
Ideally, this setup results in no net cost for entering the trade, apart from transaction fees, since the premium received from the call offsets the cost of buying the put.
Who Should Consider It
This strategy is well-suited for investors who are bearish on a particular stock and are looking for a way to profit from its potential decline without actually shorting the stock. It's appropriate for those who believe the stock will drop significantly before the options expire.
Strategy Explained
By selling a call, you take on the obligation to deliver the stock at the strike price if the option is exercised, mimicking the risk of short selling. By buying a put, you obtain the right to sell the stock at the strike price, which allows you to profit if the stock price falls below this level.
Breakeven Process
The breakeven point for a short combo is the strike price of the options used. Since the initial setup is designed to be cost-neutral, the stock price must move below the strike price by the expiration for the position to profit, similar to short selling.
Sweet Spot
The sweet spot for this strategy is when the stock price falls well below the strike price of the call and put options. The lower the stock price goes, the greater the potential profit.
Max Profit Potential
The maximum profit for a short combo is limited to the strike price minus zero (assuming a stock can't go below $0), which would occur if the underlying stock went to zero.
Max Loss
The maximum loss is theoretically unlimited because the stock price can rise indefinitely. If the stock price increases significantly, especially above the strike price of the call, losses can mount rapidly since you must provide the stock at the strike price when the call is exercised.
Risk
The primary risk with a short combo arises if the stock price increases. This strategy has similar upside risks to short selling the stock, where potential losses can be extensive if the stock price rallies.
Time Decay
Time decay (theta) impacts this strategy positively and negatively. The value of the short call position benefits from time decay as it helps the sold call option lose value faster, which is beneficial if the stock price is below the strike. Conversely, the long put position loses value due to time decay, which is detrimental if the stock price doesn't move as expected.
Implied Volatility
Changes in implied volatility can impact this strategy significantly. Increased volatility typically raises the cost of the put, which could increase the initial cost of setting up the strategy if not balanced by the call. A decrease in volatility generally decreases the value of the put, potentially reducing the profitability of the strategy if the stock declines.
Conclusion
The short combo is an effective strategy for investors expecting a downturn in a particular stock, offering a way to profit from stock price declines without the need to borrow stock for short selling. However, like actual short selling, it comes with significant risks, especially if the stock price moves contrary to expectations.