Combination strategies involve combining futures and options, options of different strikes, and futures or options of different expiry months. In this article, we discuss one such strategy — combining a futures contract with same-expiry option contract. We look at how to choose between futures and options for the primary and the secondary positions.

Optimising delta

A combination strategy is typically set up for two reasons. One, you want to reduce the capital outlay. If you buy a lower strike call and short a higher strike call, for instance, your net debit is lower than if you only buy a call. And two, you want to increase the profitability of the trade. This is possible because you would also benefit from time decay from short option positions.

Suppose you have a positive outlook on an underlying. Your objective would be to capture much of the price movement in the underlying. Now, futures move closely with the underlying than do options. That is, the delta of futures is greater than the delta of a deep in-the-money (ITM) call or put.

This sets the stage for the first argument. Your primary position should preferably be futures. That is, if you have a positive outlook on the underlying, then your long position in a combination strategy should be futures. Likewise, your short position in a combination strategy should be futures when you have a negative outlook on an underlying. This will allow you to capture maximum points from the underlying moving in your preferred direction.

Next, should you buy a put or short a call to combine with your long futures position? Some traders believe that buying a put along with long futures provides a hedge. The issue is that the hedge will not work well if the underlying declines closer to the expiry of the contract.

Suppose you go long on near-month Nifty futures, expecting the Nifty Index to move nearly 260 points to 16100. Also suppose you buy the next-week expiry 15900 Nifty put. If the index declines instead by 200 points just two days before expiry, the put could be worth only 281 points against your cost of 263 points. So, you could lose 200 points on your long futures and gain only 18 points on your puts that was supposed to act as a hedge. This provides us the second argument. Puts, as hedge, do not always offer the expected benefit in a combination strategy. You should instead consider shorting a call.

Suppose you short the next-week 15900 Nifty call for 223 points. If the underlying declines by 200 points to 15640 two days before expiry, the 15900 call could be worth 24 points. So, loss in futures is offset by gain in the call. This is not always the case; your gains from short call will often only reduce your losses on long futures. The flip side is that your gains will be capped as the call will generate losses if the underlying moves up.

Combination set-up
If outlook on underlying is positive, then long position should be futures
Short position should be futures when outlook on an underlying is negative
Puts, as hedge, do not always offer the expected benefit; instead short a call
Optional reading

An optimal condition to setup long-futures short-call combination is when you expect the underlying to move towards your target price closer to the option expiry date. The long-futures position will provide near one-to-one movement in the underlying. The short-call position will either add to the gains or will have only marginal losses, as it will lose significant value because of time decay. For instance, the 15900 call could be worth 240 points if the underlying moves to 16100 two days before expiry, causing a loss of only 17 points.

The above argument is based on a simple logic: You are unlikely to buy futures if you expect an adverse movement in the underlying immediately after you set up the long position. So, shorting a call to cushion losses on long futures could be optimal compared to buying puts as a hedge.

(The author offers training programme for individuals to manage their personal investments)

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