Which of the following statements regarding combination strategies are correct?

Option D is false. Option E is partially correct.

CAL is also known as the Capital Market Line.

A straight line (CAL) passes across the points denoting the risk-free asset and the risky portfolio in the E(r)/SD (standard deviation) space. The graph depicts the potential return that investors may make by taking on a particular amount of investment risk.

Every possible combination of risk-free and risk-bearing assets is included in the whole set of investing choices. These combinations are shown graphically on a graph with the E(r) on the y-axis and the asset's risk, as determined by the SD, on the x-axis.

The risk-free rate is the intercept of the CAL. CAL consists of combinations of risky and risk-free assets. Its slope is the reward-to-variability/volatility ratio.

The trade-off between risk and reward is represented by the CAL's slope. In exchange for taking on greater risk, investors get a larger projected return when the slope is higher.

CAL helps investors decide how much to invest in one or more risky assets (equities) and risk-free assets (Treasury Bills).

What Is a Combination?

In options trading, a combination is a blanket term for any options trade that is constructed with more than one option type, strike price, or expiration date on the same underlying asset. Traders and investors use combinations for a wide variety of trading strategies because they can be constructed to provide specific risk-reward payoffs that suit the individual's risk tolerance and preferences and expectations for the current market environment.

Key Takeaways

• Combinations are option trades constructed from multiple contracts of differing options.
• These trades can have a wide variety of strategies including extracting profit from up, down, or sideways trends in the market.
• Combinations offer carefully tailored strategies for specific market conditions.

How a Combination Works

Combinations are composed of more than one option contract. Simple combinations include option spread trades such as vertical spreads, calendar (or horizontal) spreads, and diagonal spreads. More involved combinations include trades such as Condor or Butterfly spreads which are actually combinations of two vertical spreads. Some spread trades do not have recognized names and may simply be referred to generically as a combination spread or combination trade.

Recognized combinations such as vertical spreads are often available to trade as a pre-defined grouping. But customized combinations must be put together by the individual trader and may require multiple orders to put them in place.

Depending on the individual's needs, option combinations can create risk and reward profiles which either limit risk or take advantage of specific options characteristics such as volatility and time decay. Options combination strategies take advantage of the many choices available in the options series for a given underlying asset. 

Combinations comprise a wide range of broad approaches, starting with relatively simple combinations of two options as in collars, to more difficult straddle and strangle trades. More advanced strategies include four options of two different types such as an iron condor spread. These can further hone the risk and reward profiles to profit from more specific changes in the underlying asset's price, such as a low-volatility range-bound move.

The primary disadvantage of these complex strategies is increased commission costs. It is important for any trader to understand their broker's commission structure to see whether it is conducive to trading combinations.

Some combinations are regularly used by options market makers and other professional traders because the trades can be constructed to capture risk premiums while protecting their own capital from extensive risk.

For any given underlying asset, the individual trader, commercial market maker, or institutional investor likely has two principal goals. One goal is to speculate on the future movement of the asset's price (whether higher, lower, or that it stays the same). The second goal is to limit losses to a defined amount where possible. Risk protection comes at the cost of potential reward, either by capping that reward or having a higher cost in premiums and commissions from the extra options involved.

Example of a Combination

To illustrate the concept of a combination it is useful to examine the construction of an example trade. The following example of an iron butterfly trade shows how this combination of four option contracts comes together to form a single strategy, namely, capturing profit from a stock that doesn't move outside a given range.

The investor using this combination believes that the price of the underlying asset will remain within a narrow range until the options expire. The iron butterfly is an excellent example to show the full spectrum of combinations possible because it consists of two more straightforward combinations set within the more complex butterfly structure. Specifically, it is a combination of two vertical spreads of differing types: a bull put spread and a bear call spread. These spreads may or may not share a central strike price.

An iron butterfly is a short options strategy created with four options consisting of two puts, two calls, and three strike prices, all with the same expiration date. Its goal is to profit from low volatility in the underlying asset. In other words, it earns the maximum profit when the underlying asset closes at the middle strike price at expiration.

The iron butterfly strategy has limited upside and downside risk because the high and low strike options, the wings, protect against significant moves in either direction. Due to this limited risk, its profit potential is also limited. The commission to place this trade can be a notable factor here, as there are four options involved, which will increase the fees.

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