Option Spread and Combination Trading

Abstract

Derivatives research these days is heavily focused on models. This, in turn, leads one to think about individual options, their market and model values and risk characteristics. But much of the actual trading in options and the option positions adopted by many investors are better described in terms of combinations. Every derivatives textbook offers at least a small look at the menagerie of standard and not-so-standard combination positions, such as bull and bear spreads, butterflies, straddles and strangles, and many many more. Yet little research attention is devoted to such positions. In this article, Chaput and Ederington examine large trades in Eurodollar futures options, and find that more than half of the trades and almost three-fourths of the trading volume consists of combinations. They first review which positions are common (spreads, straddles, strangles) and which are mostly just colorful names (butterflies, condors, iron flies, etc.). They then consider the reasons for trading combinations. One is that these positions often focus exposure on specific risk factors, especially volatility, while minimizing exposure to others, to an extent that is often not feasible with single options. A second reason to trade combinations is the possibility of reducing the effective bid-ask spread. Although the evidence is a bit circumstantial, it does suggest that spreads for combinations are smaller than for straight purchases and sales of individual options.