What are combination trades?
Combination trading is a strategy to achieve greater returns or lower risk by entering into multiple futures contracts for the same commodity.
By exploiting the relationship between different arrangements, one could construct a “synthetic” position similar to an outright long or short position in a physical market.
The simplicity of this strategy makes it ideal for new traders who have little capital but wish to trade on margin.
Example: Outright vs Futures Margin Trading
Trader A buys one futures contract at $15, while Trader B buys ten futures contracts each at $10.
Both traders are long in their respective markets and will profit/lose from changes in the underlying asset’s value (e.g. stocks).
Outright Margin Trading
Trader A will need to pay $1500, while trader B will need to put down $100 for each contract. This means that any price fluctuations in the market will affect traders A and B differently.
In our example, if the underlying asset falls from $15 to $13, both traders will lose near identical amounts (-$200).
Futures Margin Trading
If both traders were trading futures instead, all they would have needed to do is pay a single margin on their net position ($1500) rather than per contract ($100 * 10 = $1000).
This means that trader B, who holds more contracts, has built-in leverage to benefit significantly from small movements in the market.
Combination Trading Exploit
By buying one contract for $15 and selling another contract at $14.50, trader A has created a synthetic short position of 1 futures contract worth ten stocks.
This is because the value of the two contracts is very close to each other, so for all intents and purposes, trader A can say he owns ten stocks outright.
On the other hand, Trader B enters into two separate long positions in the underlying asset (10 contracts each).
The simplicity of this strategy makes it an attractive option for traders looking to enter into multiple futures contracts without having to lay down collateral for each trade or worrying about margin requirements etc.
As seen above, combining existing transactions could give you enormous leverage over your peers trading in the same market.
Trading Example for Combination Trading
Trader A would like to short the underlying asset by selling Z number of shares at price S or buy X number of shares at price F.
Suppose he does not have the capital required to do so outright.
In that case, he could “synthetically” create these positions by entering into an equal value of two different types of trades available on the market.
These might include a futures contract against an index with a 3% interest rate and a futures contract against stocks at 2%.
By doing this trader, A now has access to another type of trade that can be used to achieve his desired position.
Similarly, if he wanted to take a long part, i.e. buy X number of shares at price F, he could enter into a combination trade by shorting an index with a 5% interest rate and shorting stocks via futures contracts at 4%.
This strategy is only possible if the two contracts are highly correlated.
As seen above, entering into a long/short position on one type of asset vs another will give you access to all third party trades which are similar to these two types of investments.
The more significant the correlation between these two assets, the easier it will be for the trader to find the combination trades that can achieve desired positions.
How to Trade Combination Trades?
The simplest way would be using a trading platform provided by your broker, which usually has pre-built functions that allow for such type of trading.
Using the example above, trader A would be able to enter into a long or short futures contract at price L and M respectively through such an interface (assuming the platform supports such trades).
Although this will increase your margin requirement slightly since you are growing transaction size by creating synthetic positions, it is still advantageous compared to buying/selling assets outright without using these particular strategies because, unlike margin requirements which vary based on asset type and average daily volume, interest rates remain constant across all types of assets.
The beauty of trading financial instruments is the ability to create an infinite number of strategies based on market conditions and personal preferences. There are hundreds of methods available for traders.
Still, not all trades will be suitable based on your risk profile, so it’s essential to understand what each transaction entails before entering into them.
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