A risk free trade. It sounds great doesn’t it? Just put on as many of these trades as you can because it’s a sure thing. You can’t lose money. I remember attending an option trading seminar years ago with a trade they created with a risk chart completely above the zero profit line. You couldn’t lose. That’s what it looked like. After I came home from the seminar, I tried to find this type of risk free trade but never could duplicate it. Is there really such a trade?
No. Every trade has risk
There are two types of risk in “risk free” trades:
– Risk you don’t see
– Risking unrealized profits
Let’s take a look at each of these types of risk.
Risk you don’t see
In the case of the option trade I was trying to duplicate, the risk I wasn’t seeing involved volatility. Option prices have many components, but volatility, price and time to expiration are big factors. If you have options with different expiration months, you DO have volatility risk. Just look at your Vega.
Any calendar spread trader will tell you about volatility crush. This is when your long Vega time spread gets hammered when volatility collapses. The whole risk chart shifts down and can turn a beautiful risk chart into an ugly nightmare. When evaluating any option position, especially if it involves multiple expiration months, you have to consider what you volatility risk is, or Vega. It’s not shouting at you like a chart, but it’s a hidden shark waiting to get you if you aren’t careful.
Risking unrealized profits
This one really bothers me. If you buy an at-the-money call and your underlying stock goes up, your call should profitable. What happens if you sell two calls against it and buy an additional call to create a butterfly spread. This butterfly spread has a risk chart completely above the zero profit line. You can’t lose right?
The way I think about it is what would it cost to put on that butterfly spread if I didn’t have any open positions already? The risk involved in the new position, is the risk you are taking. You are paying for it with unrealized profits, but your alternative is to close your position and walk away.
In our example, if our call had a $300 profit and the butterfly had a maximum risk of $250, you are risking $250, even though your trading software says the worst you can do is make $50. You can pocket the $300 and not open the butterfly spread. You avoid the hidden risk of $250 by closing the trade entirely.
Can you find the risk?
The next time you see a risk free trade, look for the risk. It’s there like a shark, waiting for you. The two most common places you’ll find the risk are volatility or using unrealized profits. The two quick tests are checking the Vega and asking yourself what the risk would be if I didn’t have any open positions.
If it looks too good to be true, it probably is.