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Risk Free Option Trading

Risk Free Option Trading Using Arbitrage Techniques

People are always wondering if there is a way that you can experience risk free option trading and get away with it. Is it possible that, once you enter your position, there is 100 percent certainty that you will make a profit?

The answer is 'yes'.

In this article, we will discuss how risk free option trading works, but need to preface our remarks by saying that we assume you understand how stock options work and in particular, concepts such as 'in the money' 'out of the money' etc ... 'time decay' 'strike price' 'assignment at expiration' and 'expiration date'.

If you're a bit more advanced and know what 'implied volatility' means, it will be a bonus but not essential.

If you don't understand the above concepts, you need do some basic reading first, then return and have a look at this.

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How Risk Free Option Trading is Structured

You can do it one of two ways.

The first way will require a larger amount of capital and therefore, your return on risk will be smaller.

The second way achieves the same result but with less capital required.

Risk Free Options Trading - Method 1

You have probably heard of a 'covered call'. This is where you purchase shares and simultaneously write (or sell) call options over the same number of shares. For US markets for example, it would be multiples of 100 shares.

The essential part of this strategy, is that the written call options are "in the money". You want the current market price of the stock to be above the strike price of the call options, at the time of entry.

The next thing you do, is buy the same number of put options, at the same strike price and expiration date as your 'sold' call options.

These put options will be 'out of the money' and will therefore be cheaper than the written call options. Assuming there are no 'implied volatility' anomalies, the difference between option premiums from your sold and bought positions will produce a credit to your account.

Now here's the important part.

You need to ensure that the difference between the current market price of the underlying stock and the strike price of the bought and sold options, when you do this, is less than the credit you have received from the call/put setup above. Don't forget to take brokerage costs into account.

This difference is your locked in profit. Whatever happens from now on, you cannot lose money. Let's take an example to illustrate the point.

A Risk Free Option Trading Example

The market price of XYZ is currently $61.35.

You buy 1,000 shares and simultaneously sell 10 x $60 (in the money) call option contracts, receiving a premium of $4.90 per contract, or $4,900.

You also buy 10 x $60 put option contracts at $3.10 per contract (they are 'out of the money' therefore cheaper) which costs you $3,100. The overall credit is $1,800.

The difference in option premiums above is $1.80 but the difference between $61.35 and $60.00 strike price is only $1.35. The 45 cents per share therefore, is immediate locked in profit at expiration date, no matter what happens after that.

Let's say that by expiration date, the share price has risen to $65. Your bought put options will expire worthless and your sold call options will be $5,000 in loss. But your purchased shares will be $3,650 in profit. Putting it another way, the shares that you purchased for $61.35 will be "called away", forcing you to sell them for $60.00.

The difference between these two is $1,350 loss. But you have received $1,800 credit from your option strategy so you make an overall $450 profit, less brokerage costs.

If, on the other hand, the price of the XYZ has fallen at expiration date to say, $55 then we have the following scenario.

Your sold call $60 options will expire worthless, leaving you a profit on these, of $4900.

Your long put $60 options will now be worth $5 per share. Since you bought them for $3.10, they realize a profit of $1.90 per share, or $1900.

Your shares however, are standing at an unrealized loss of $6.35 per share ($61.35 - $55.00), or $6350.

Since your total profit from the options is $6.80 per share while your total loss from the shares is $6.35, you're still ahead by 45 cents per share, or $450 for the 1,000 shares.

Call options by nature, are normally more expensive than put options, because their upside potential intrinsic value is theoretically unlimited, whereas the intrinsic value in put options can only be the difference between the current share price and zero. But if you understand something about implied volatility in option pricing, you will understand that this may not always be the case.

The implied volatility in call options tends to fall away as the price action of the underlying is reaching a perceived major peak and is now ready for a pullback.

Return on Risk - Observation

Having said all this, we would be remiss if we didn't make the following observation:

The cost of your 'risk free' investment, is 1,000 x $60 for the shares, which equals $60,000.

A $450 return on having $60,000 tied up until expiration date, may not be considered a good return on investment . . . 0.75% to be exact. Even if each option contract expired in 30 days and then you moved on to the next one, this is only 9% per annum. It's still better than dividends (but you can collect these two if you time things right).

Risk Free Option Trading - A Cheaper Alternative

Looking at the above, you're probably thinking that $61,350 is a lot of money to invest in shares for a tiny $450 profit at option expiration date. But what if you could achieve the same result without such a large outlay?

Would that be more attractive?

Remember, the only reason you bought shares in the above example, was to hedge against the loss on your sold call options. What if there was another way you could achieve the same result, but with only about 5 percent of the outlay?

One way would be to create a "synthetic stock position" using options. To do this, you simultaneously buy calls and sell the same number of puts, both at the same strike price and expiration date. You may need to check your brokerage requirements for margin when doing this.

There are however, other derivative instruments that you can use to hedge your position instead of buying the shares, including index or commodity based futures contracts and if you live outside the USA, Contracts For Difference (CFDs).

Unlike options, index based futures and CFDs (assuming you're allowed to trade CFDs in your country) have a delta of 1 - i.e. one point for every one point that the underlying moves.

You can use this difference in delta to your advantage.

For our purpose, let's illustrate with contracts for difference (CFDs). CFDs don't have fixed 'strike prices' like option contracts, so instead of buying 1,000 shares, you can take advantage of this by going long 1,000 XYZ contracts for difference at $61.35.

You would do exactly the same as outlined above, except that instead of needing $61,350 in your account to buy the shares, you only outlay about 5 percent of the overall share value, which is $3,068 plus brokerage, plus interest on the remaining 95 percent ($58,282) for the duration of the trade.

If the share price rises to $65 your CFDs would be $3,650 in profit, (65.00 - 61.35 x 1000) replacing the share profit mentioned earlier. A guaranteed profit of around $400 after brokerage on an outlay of $3,068 is about 31 percent return on investment, per option expiration cycle, totally risk free.

Now that's more like it!

Doing it in Reverse

Why limit yourself to selling calls and buying puts? To construct a risk free option trading setup, you may be able to reverse the above structure, given option implied volatility at times.

Under these conditions, why enter a CFD contract when you can simply sell short 1,000 XYZ shares at $58.65 and collect $58,650 plus interest for the duration of the option period instead, then offset it with your sold $60 ITM put option and hedge it with your bought OTM $60 call option.

Put options will often become more expensive than calls, due to increased implied volatility, at the top of a trading range when a reversal is expected.

Final Thoughts

For the above risk free option trading strategy to work, you may have to do some homework, including researching broker fees for the above transactions and constructing a spreadsheet that will allow you to quickly analyse the return on outlay, after brokerage.

For the cheaper strategy, using futures or CFDs, you will want to ensure that your broker will accept the long CFD contract as an acceptable hedge against your 'naked' sold call options. If not, then you may prefer the "synthetic stock options" route, mentioned above.

In other words, a broker who only provides option trading services may not recognize your CFDs in another broker account, so you may want to find one broker who offers both. Some CFD brokers such as IG Markets, include both CFDs and options on indexes.

Finally, always always know what your broker fees are for the above, at entry and option expiry. They will be critical in determining how many option contracts you need to enter to make a profit.

If this all seems out of reach, there are three strategies, designed specifically for the US markets (where CFD trading is not allowed) which teach highly profitable options arbitrage techniques.

They are part of a High Level Options Mentoring video training course designed by well known veteran trader, David Vallieres.

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