Advanced and Combination Strategies
What this domain tests
Combination strategies test whether you can classify a position by its volatility and direction view: straddles, strangles, butterflies, condors and ratio spreads. Questions often ask for maximum loss, breakevens and the market view implied by the structure.
Core rules
- Long straddle = long call + long put at same strike and expiry. Long volatility; unlimited profit either way; maximum loss = total premium; breakevens = strike ± premium.
- Long strangle = long OTM call + long OTM put. Cheaper than a straddle but needs a larger move.
- Long butterfly = buy one lower-strike call, sell two middle calls, buy one higher-strike call (or the put equivalent). Limited risk, limited reward, profits from low volatility and pinning near the middle strike.
- Iron condor = short OTM put spread + short OTM call spread. Credit strategy; profits if the underlying stays in a range; risk is defined by the wings.
- Ratio spread = buy one option and sell more than one further OTM option. It can turn into naked short options beyond the upper strike, so tail risk is significant.
Worked example
A stock is at ₹100. Buy the ₹100 call for ₹5 and the ₹100 put for ₹4; total premium = ₹9. Maximum loss is ₹9 per share if the stock expires exactly at ₹100. Upper breakeven = 100 + 9 = ₹109; lower breakeven = 100 − 9 = ₹91. At ₹115, the call is worth ₹15, so profit = 15 − 9 = ₹6. At ₹85, the put is worth ₹15, so profit is also ₹6. The position makes money only if realised volatility produces a move larger than the ₹9 already priced in.
Traps
- Forgetting that a long straddle loses when the stock pins the strike, even though the trader was "right" on volatility direction.
- Treating a credit iron condor's maximum profit as unlimited.
- Ignoring the naked-short leg in a ratio spread.