5.4. Summary

Investors have learned to combine call and put options in a variety of creative ways to take advantage of various situations and protect themselves against risk. We have examined but a few of the synthetic options, combinations, and spreads in the investors’ toolbox.

Synthetic options offer the combination of long and short futures contracts with simple calls and puts. They provide hedgers and speculators with a certain flexibility to move out of one position into another quickly and cheaply. They also promise greater leverage than simple calls and puts because their lower risk allows for lower margin requirements. Like simple options, synthetics take a position on the direction of market prices in the underlying instrument.

Investors also use vertical spreads to speculate on the direction of market prices. Vertical spreads are the purchase and sale of either two puts (put spread) or two calls (call spread) at different strike prices. A long call or put spread (debit spread) costs a net initial outlay. Its investors hope to see their two premiums widen and their position to terminate in the money. A short call or put spread (credit spread) gains a net initial revenue. Its investors hope to see their two premiums narrow and their position to expire out of the money. Unlike synthetic options, investors in vertical spreads expect and desire little price movement. With both long and short positions, investors have chosen to cap potential gains in order to limit potential losses.

While vertical spreads and synthetics speculate on the direction of the market, combinations, such as straddles and strangles, speculate on the volatility of market prices. Combinations are the purchase or sale of both a call and a put on the same underlying product at the same price and the same expiration date. Long combinations speculate that an asset is highly volatile and its direction unpredictable. Short combinations speculate that an asset will not be vola