Risk Free Option Trading

Risk Free Option Trading Using Arbitrage Techniques

People are always wondering if there is a way that you can engage in 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 expiry' and 'expiry 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.

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.

Let's discuss the first way.

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. On the USA markets for example, it would be multiples of 100 shares.

The vital 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 amount of put options, at the same strike price and expiration date as your 'sold' call options. Your put options will be 'out of the money' and will therefore be cheaper than the written call options. 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, which would normally be around $90 to enter and exit the trade.

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 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 therefore is immediate locked in profit, no matter what happens after that.

Let's say that by expiry 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. 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.

Call options by nature, are normally more expensive than put options, because their upside potential intrinsic value is 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.

Risk Free Option Trading - The Cheaper Way

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. You would be right of course - it's only about 1 percent return on investment. 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?

There are other derivative type instruments you can use to hedge your position instead of buying the shares, including futures and CFDs. 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 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 $3,068 in profit, 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 expiry 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 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. 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 a bit too complicated, there is another strategy aptly named 'Victory Spreads' you may like to consider. These are a variation of the back-ratio spread, but with unlimited upside profit potential and virtually zero downside risk - a truly "set and forget" type of option trade.

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