This strategy is sure seeming like a free lunch to me, but I can’t see what I’m missing. I feel like an idiot.
Buy an at the money put for $2, sell an at the money $3 call, then buy the stock. Collect the dividends from the stock and the $1 net premium, then sell the stock when the options expire. If the stock declines the value of the put will bring you back to the purchase price. If the price increases, you are brought back to the purchase price when the option is called.
Obviously there’s no such thing as a risk free return like this…so what am I missing?
OK… at first I was confused because it does appear on option chains that there is a price difference beween the ATM call and put values and getting a higher call premium than what you pay for the put is key in your strategy. Here is the thing… option strikes are at interval values while the actual stock price fluctuates in bewteen. That is what causes the difference in put and call premiums and that is what will foil your plan.
For example… looking at BAC option chain… for the ATM 13.5 strike you can sell at call at .31 and buy the put at .05. However, the stock price is at 13.76 (not 13.5)
If you think after all is said and done at expiration you get to keep the .26… think again. If the stock goes down to $13.00, you have permission to sell the stock at 13.5, not 13.76. You will not recoup your loss. that “extra .26” is the difference bewtween .5 and .76
With the dividend, I belive that stocks with a dividend have higher put premiums so you surely won’t be able to count on getting that higher premium for the short call. So, you won’t be able to win buy collecting the dividend even if the rest of the strategy works out to a break even.
You’re right this would be a riskless trade. Most conversions/reversals will actually cost money - in the rare event the pricing looks to offer a profit you can be sure it’s for a good reason. Usually shares are hard to borrow or you’re not correctly pricing a dividend.
The first step would be to look at a real example with details. Are you looking at live tradeable bid/ask or stale trades?
I pulled the numbers from Potash Corp. They’re a bit rough, but if I remember correctly the put was 2 bucks and the call 3, and the stock was at 24.85. At the time the numbers were live.
Even if I can’t pocket the net premium, why wouldn’t I do this and simply collect the dividends, rather than buying a bond. Is the only risk then the chance that the dividend is reduced below what a riskless bond would pay? Because…that seems likes an awfully good deal. If I can use the put/call to erase risk (without having to pay a net premium) in the stock, then simply collect whatever dividend the company gives out (Potash has a big yield right now, and I’m sure it will fall…but to less than 3%? I doubt that) why wouldn’t I do that? No risk with a much bigger return than a treasury. Unless I’m still missing something.
I believe the market makers will be one up on you. As I mentioned above, the spread between your ATM short call and long put should be equivalent to the spread between the strike and the current market price… BUT if there is a dividend envolved, the spread between the short call and long put will be less than the spread between the strike and market to compensate for the dividend.
I just took a look at the ATM Jan 17 situation for BAC. Their dividend sucks, but indeed you see, the spread between the long call and short put is only .64 but the spread between the strike and market is .66/
I’m not entirely sure what you mean. When you say the spread between the put and call, I’m assuming you mean the spread between their premiums?
To be honest, it wasn’t the net premium that initially made me think about this strategy. It was the concept of getting to collect dividends, which are very likely to be higher than a riskless bond, without having to hold the risk of the underlying. I need money a year from now, and I can’t accept any loss of capital, but I’d still like to earn more than a measly 1%.
Ya, this would be a pain. I’d have to sell the stock and the put. However, if it was called early, the call and stock would wash out, but the put would still have some time value, so I’d make a small profit there. However, if the stock did really well and the call was called early, the put would have very little value and I’d have to pay new commissions to reset my position.
I thought at one point about trying to short a future and hold the stock, thinking it would get me risk free dividends. I knew implicitly that this probably shouldn’t be possible, but couldn’t figure out why.
It turns out that the roll yield on the future is where the dividend comes in (assuming there is no dividend surprise, which is a more complicated). So every time you reinitiate the short position, you end up a little less, by the PV of the dividend.
The long put and short call, both ATM, is effectively a synthetic short future and presumably should have the same dynamic going on.
what I mean is the system of the short call, long put and stock will not only not have premium from a call priced higher than then put…but the system will actually net a negative figure at expiration which will counter the dividend.
example
buy AAPL at 106.13… sell ATM call at 9.90… buy ATM put strike 105 at 9.58 (actual values from today)
to make it simple, lets say AAPL goes down to 105 at expiration
lose 1.13 on stock
gain 9.90 on call (OTM, keep premium)
lose 9.58 on put (used at expiration)
so thats -1.13 -9.48 +9.90 = _ negative .71 _
_ _(those sneaky market makers!)
EDIT … I am using the Jan17 105 strike in the example
…actually, there is something wierd going on. I went to look at a stock that does not have a dividend to see the 3 position set up would break even at expiration as I expected.
Here is FB exp Jan17 ATM strike 110
market 112.54 call 14.33 put 10.95 This actually looks like it would lock in a profit of .84.
here is the math again. This time I will use the example of the stock going up, but it does not matter.
at expiration stock is called away at 110 (lose 2.54)
KMD - That’s a hair better than buying a risk free treasury…add commission and bid/ask and it’s slightly worse. The conversion is lending, flip it around and you’ll see the reversal is borrowing. It’s equivalent to going long or short the box…or trading interest rates, except with way more slippage and pin risk. Options are priced on the forward.
ST - The only way you could capture the dividend would be if you were using a DITM call and someone forgot to exercise. It’s just not going to happen or be worthwhile to pursue as a strategy but by all means feel free to load up on conversions and see for yourself.
Right idea but not completely there. The margin requirement for this trade is going to be incredibly low, around $1000, so the return on capital would still be pretty large. $84 for $1000. I do wonder if there is any expected dividend in the next year… but for FB I doubt it.
Beyond that, I am not entirely sure. I looked at the liquidity and even buying at the ask and selling at the bid you’d be ahead.
As the saying goes though… there’s no such thing as a free lunch. But for this, at least on the surface, you may be getting prime rib for the price of a burger.
This is put/call parity…she bought 112.54 and sold 113.38. Margin has nothing to do with it - eurodollar rates aren’t 1600% because margin on a contract is $275.
Well it’s a riskless trade cause you are earning the risk-free rate on your investment. Why not take the money you were going to use to buy the stock, put $1 in your pocket and invest the rest in a treasury bond?
Margin has everything to do with it. You’re earning way more than the rf rate. I could take a $100k account, put on 100 of these trades and earn $8400.
To go back to my original question, I realize I made the boneheaded mistake of thinking the put price was the call price, so in fact the put was priced higher than the call. And, if I recall correctly, dividends are priced in on the right side of put-call parity, so that would explain why the put is priced higher - otherwise I could collect the dividends without risk.
But then the question is…why is FB’s call priced higher than the put? Do they pay no dividend?
Also, noob question here…I haven’t traded options before so I’m ignorant with commission prices. One I’m seeing is 9.99+1.25 a contract. When they say a contract, do they mean per option? Because that is ridiculous…how could a person ever use options on a sub $10 option when you’re paying 13-50% commission right off the top? I really hope I’m understanding this wrong…
Yeah, I was surprised that the put would be priced lower than the call, but I thought maybe the dividends had some unexpected effects and was too lazy to go figure it out.
Theoretically, if there aren’t dividends, the put price and the call price should be the same. In practice, the put is sometimes higher than the call because people are usually willing to pay extra for protection. The dividend should lower the call price, and (I think) raise the put price (since going ex-dividend will make the stock price drop, thus making it more likely to be in the money by the end).