The Risk Free Spread. Yes, You Read That Right.

I’m not usually one for sensationalism. So okay. “risk free” is a matter of interpretation. This is a very simple trade and we’ll use MDR as an example since everyone and their mother (including me) tweeted about it when bullish order flow hit the options market. Essentially what I’m talking about here is converting and at-the-money vertical spread into a Butterfly. This type of trade can be done no matter what the entry, but it works best when the initial trade is a close-to-the-money credit or debit spread.

On Oct 3 rd. when the bullish paper hit the book, the Oct 12/13 Call Debit Spread was priced at roughly $0.28 during the mid afternoon with MDR at about $11.5. The risk profile is shown below.

By Oct 6 th. MDR hit a high of just about $14.5 and the Oct 12/13 Debit Spread was at a considerable profit of just about a 100% gain.

With these kinds of profits, one might simply take the money, but another route that we can explore is to lock in profits by selling a spread against the original trade, as is shown in the next image:

In this particular example, we’ve added an Oct 15/16 Bear Call Spread to the original position for a credit of 40 cents. Notice that the maximum loss is now a profit. In other words, this trade cannot lose! It still retains some bullishness to it, but if resistance holds (see the chart below), the trade will add profit if price should remain range bound.

In this example, this is exactly what happened. Below is the risk chart showing today’s price as I write this. Notice that while the trade removed all the risk from the table, the profit has tripled from the time the bear spread was added.

I like managing at-the-money or close-to-the-money spreads in this way, but hopefully it is not too much of a stretch to see how this logic can be expanded to other types of spreads as well. An opposing position can always be added to a trade and the credit from the new position will reduce the margin of the original trade. In some cases, this can result in a risk free butterfly.

For those interested, I am in planning to teach an advanced Vertical Spread course. I’ll be focusing on Verticals and risk equivalent positions. Amongst other things, we’ll look at how to chose one position over another and how to best manage (adjust) them when things don’t work as planned. The course will go for about two months or so and cost will be minimal (relatively speaking). If you’re interested in being notified when the time gets closer, shoot me an email at info at optionworkshop dot com.