They sure can! Remember that options are choices: the right, but not the obligation, to do something, usually buying or selling. When you combine options with other investments, or options with other options, you may get a combination that helps you make some sense out how an investment strategy might work..
First, we need a quick course on option pricing. An option price has four major components: the underlying stock’s price, the strike or exercise price, the time left until the option expires, and the volatility of the underlying stock. Say you wanted an option to buy or sell shares of Apple at $175 per share that expire in a month. You would have to pay $4.46 for the call option, and $3.52 for the put option. The put option is a little less expensive, because Apple shares closed at $175.52 per share last night. There’s a whole “chain” of option prices for any particular expiration date, options that are out of the money, at the money, or in the money – where the strike price is below the market price
In this example, if you purchased a 175 call option and simultaneously sold a 175 put option, you’d have pay 94 cents. 52 cents of that price is the difference between the actual price of Apple and the $175 strike price, and 42 cents is a bullish premium built into the options pricing. Short call options are usually a little more expensive than put options. By combining a long call and a short put with the same strike price, you’ve created a synthetic futures contract. In fact, there are all kinds of options strategies where you combine buys and sells to create a unique payout structure. The varieties and their associated names – call spread, put spread, back spread, butterfly, straddle, condor – are endless.
Source: Options Industry Council
But we can also look at combining different kinds of instruments. A corporate bond could be considered the combination of a risk-free Treasury bond and a short put on the corporation’s credit. The management has the right to sell ownership of the company to the bondholders by filing for bankruptcy. There are two important things to know with any option strategy: when you buy an option, time works against you, but volatility works for you. When you sell an option, time is on your side, but volatility is against you. So to go back to corporate bonds, when you buy a corporate bond, you want the world to be boring. You can earn more than the risk-free rate, as long as the world remains stable. You want the puts that you’ve written to management to expire worthless.
There are a whole host of financial instruments that can be considered combinations of options with other items – like risk-free bonds, or market indices, or economic growth. By looking at how options behave, we can see what makes market strategies work – and why they might not work.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”