Amazingly low risk spread!!

[mirolho]

Hello all. Im new at this forum.
I have found an options spread possibility that (in theory) has VERY little risk (almost 0) and a reather good return (from my calculations, 200% a year or more).
Its basically a bull call spread (buy a call at one strike price and sel another call at a higher strike, with the same expiration). The difference is that you buy a call with the lowest strike possible (example: on eurusd, use calls with the strike price on 0,2000) and the furthest expiration date (example: june 2009). And you sell a call with a strike on a price that you think(almost for sure) the spot will not reach by the time of expiration (example: i am almost sure that EURUSD will not be at 1,1000 by june of 2009).
Before you call me crazy, i just want to say that i know that on normal conditions this spread would have a 0 profit potential, because the spot is already way above the maximum profit. This is not the usual way to apply a bull call spread.
However i have noticed that calls with low strike prices (ex: 0,2000) have a positive time decay because their price is below the price it should have.
example: the june 2009 0,2000 call, right now, has the price of 1,2970, and the spot is 1,5665. This option should be worth at least 1,3665, if it had no premium. And i have noticed that if the spot price stays the same, by the time of expiration, the option with reach its real price. So, if by june of 2009 eurusd is stil at 1,5665, the option will be worth at least 1,3665, with a gain of about 700 points. And the lower the strike price is, the greater is this difference between real price and momentary price
But if you just buy an option like that, you are vulnerable to the movements of the spot price. Thats why you go short on a call with a higher price. This way you can hedge a position and will only lose money IF the spot price goes lower than the strike price of the option you went short on.
So, to demonstrate on a real example, i will buy a june 2009 0,2000 EURUSD call and sell a june 2009 1,1000 EURUSD call, because i am almost sure that EURUSD will not be at 1,1000 by june of 2009.

The options, right now, are priced, respectively, at 1,2970 (ask) and 0,4258 (bid). ANd the spot is 1,5665

Say I operate with 100000 of each. I would spend 129700,00 USD on the first and receive 42580,00 USD on the second. So i would actually spend 87120 USD (871 with a 100:1 leverage).

Now lets look at the results:
If by june of 2009 the spot is the same (1,5665)
The call i bought will be worth 1,3665. I win 695 points (6950 USD)
The call i sold will be worth 0,4665. I lose 407 points (4070 USD)
So, in the end, i profit 2880 USD, with a 870 USD investment, more than 200% in one year.

If by june of 2009 the spot is at 1,1000 (almost impossible)
The call i bought will be worth 0,9000. I lose 3970 points (39700 USD)
The call i sold will be worth 0. I win 4258 points (42580 USD)
So, in the and, i profit 2880 USD.

You get the picture. In this particular position, as long as the spot is above 1,1000 by june of 2009, i will profit the same (2880 USD with an investment of 870 USD).


Please comment on this proposal. Because it works in theory, i would like to know from you guys if there is a reason why this wouldnt work on a live account.

Thanks

 

[jamescummins]

In short, you are making money betting the highly unlikely wont happen. That is a slippery slope to seeling deep out of the money options since they show time decay, and are highly unlikely to be exercised. Having a risk of very nearly zero, is a long way off zero. Trading on 100 to 1 leverage simply makes it worse / better. You are basically receiving money by betting on nothing completely unexpected happening. If something completely unexpected does happen, you lose everything!!

The fact that it is not risk free, is why this opportunity presents itself. Someone is prepared to pay you not a lot for the options, on the basis that if something mental occurs, they have got some protection for next to nothing. If you think in terms of oil, it is like buying a put struck at 50USD and Selling 100USD puts. The value that the option 'shouldnt have' is because of the skew.

Only read it briefly, and I now cant even remember what my point was, so apologies if I completely missed what you were suggesting!!

 

[mirolho]

In short, you are making money betting the highly unlikely wont happen. That is a slippery slope to seeling deep out of the money options since they show time decay, and are highly unlikely to be exercised. Having a risk of very nearly zero, is a long way off zero. Trading on 100 to 1 leverage simply makes it worse / better. You are basically receiving money by betting on nothing completely unexpected happening. If something completely unexpected does happen, you lose everything!!

The fact that it is not risk free, is why this opportunity presents itself. Someone is prepared to pay you not a lot for the options, on the basis that if something mental occurs, they have got some protection for next to nothing. If you think in terms of oil, it is like buying a put struck at 50USD and Selling 100USD puts. The value that the option 'shouldnt have' is because of the skew.

Only read it briefly, and I now cant even remember what my point was, so apologies if I completely missed what you were suggesting!!

i think you got it.
I agree there is some risk that the unexpected will happen. But the eurusd will not fall 30% overnight. If it gets close to the point where i start losing money, i can just close the position. Depending how long it takes to get there, i might even win some money. Because i start off losing the spread, say if its 7 pips on each option (thats th target spread on saxobank), i start losing 140 USD for 100000 options (with a ~870 USD investment). So if i open this position and imediately the EURUSD starts to fall a lot, but i manage to sell before it gets to 1,1000, i think i would only lose 140 USD (around 20%). And after a couple of months you would have already won back your 140, so even if you get stopped out, you would win some money.

I didnt check these calculations too much, so if you think they are wrong just tell me

So i think to myself: what are the odds of eurusd falling to 1,10? And what are the odds of it to be so fast that i cant even close my position before i happens?
Whatever the odds are, im sure they are low, and im willing to take that risk for a nearly 200% profit a year.

Im just a little suspicious of this trade because it sounds too good to be true. Thats why im asking to anyone of this forum to say if this wouldnt work on a live account

Thanks for the reply

 

[davedavethetrader]

if eurusd falls to 1,10 the odds of it being fast are large. What would make that happen? thats the clincher... if you can work out your 'black swan' event then maybe you could invest some of your future 'profit' in some protection via stock index options. just a thought...

anything thats looks to good to be true, is. especially with options!!!!!!!!! ALWAYS!!!! i swear option pros actually have crystal balls.... just like life insurance companies actually employ the oracle from the matrix.....

 

[abottoml]

Sooner or later, the Black Swan will visit:

Amazon.co.uk: The Black Swan: The Impact of the Highly Improbable: Nassim Nicholas Taleb: Books

 

[mambo5]

I think the answer may be a lot more obvious, it centre's around the 100:1 leverage! Where are your financings costs in the example, presumably you have to pay interest on the leverage. Forgive me if i'm wrong but when you buy an option on some exchanges you pay the premium upfront, so in your example (in the absence of leverage) you will have invested 87,120 to make a return of 2880 in a years time. That is about a 3.3% annual return. Plus you are effectively short the 1.10 put as a previous respondent has alluded to. Now you mention getting out if the market falls to there, has no one told you yet that there are no free lunches left in the markets? You would already have suffered considerable losses, to highlight this just analyse the effect on the price of the 1.10 put that you are effectively short if the spot price falls from 1.57 to even 1.30, nevermind 1.10!

 

[mirolho]

I think the answer may be a lot more obvious, it centre's around the 100:1 leverage! Where are your financings costs in the example, presumably you have to pay interest on the leverage. Forgive me if i'm wrong but when you buy an option on some exchanges you pay the premium upfront, so in your example (in the absence of leverage) you will have invested 87,120 to make a return of 2880 in a years time. That is about a 3.3% annual return. Plus you are effectively short the 1.10 put as a previous respondent has alluded to. Now you mention getting out if the market falls to there, has no one told you yet that there are no free lunches left in the markets? You would already have suffered considerable losses, to highlight this just analyse the effect on the price of the 1.10 put that you are effectively short if the spot price falls from 1.57 to even 1.30, nevermind 1.10!

I believe there are no costs to use leverage, at least thats what my broker told me when I emailed her this question. I think thats just the way forex works. If you buy eurusd and it goes up 1 pip, its less than 0.01%, but you gain 1% in your account (assuming you buy 100000).
Anyway, what I WOULD pay would be the interest differential, but options, as far as i know, dont have interest, and even is they did, i wouldnt have to pay anything, because i am long in one call and short in another, so the interest differential would even out.

About the exit strategy, IF the eurusd goes down to 1,20 it would do horrible things to the price of the call i bought, but the call i sold would also lose a lot, so it would shrink my losses. According to my calculations, i would lose only the spread, wich is about 140 USD on eurusd options.

Anyway, im not sure if options do or do not gain interest, but if i find out ill post here

Thanks for the reply

 

[A Dashing Blade]

However i have noticed that calls with low strike prices (ex: 0,2000) have a positive time decay because their price is below the price it should have . . .

Not a ccy options expert but I would guess that's because of the interest -rate differential.

ie you're effectively buying an option whose current underlying is the forward fx rate iyswim.

 

[mirolho]

Not a ccy options expert but I would guess that's because of the interest -rate differential.

ie you're effectively buying an option whose current underlying is the forward fx rate iyswim.

i agree. If the very-in-the-money calls had a normal price (at least the implied value) we would have a very low risk carry trade (buy spot and sell very-in-the-money calls, i would only lose if the spot would go below the strike price).

But since i dont pay/earn interest on the options, i can take advantage of the fact that these options are undervalued.

 

[A Dashing Blade]

But since i dont pay/earn interest on the options, i can take advantage of the fact that these options are undervalued.

Then you don't understand what I said.

June '09 GBP (11M) forwards are currently trading at -440 mid.

 

[mirolho]

Then you don't understand what I said.

June '09 GBP (11M) forwards are currently trading at -440 mid.

Im sorry, but i dont understand how that would change anything. If i buy a 0,20 call and sell a 1,10 call, by the expiration date i will buy the spot for 0,20 and sell it for 1,10 (0,90 profit). But i will pay less than 0,90 for it.