Taking Free Options Position Applying Zero Cost Option Strategy

Zero Cost Option Strategy as the name suggests is an option trading strategy in which you could take a free options position for hedging or speculating in equity, forex and commodity markets. This strategy is also known as Risk Reversal Strategy. In this article, we will apply this option strategy on particular stock as an example and would see how simple the logic is while executing zero cost option strategy.

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Constructing a Zero Cost position

This strategy can be built in two ways:

1. When you are bullish in particular stock then opt to build bullish position as discussed below:

Buy out-of-the money call option and simultaneously sell out-of-the money put option in same stock for that month.

2. When you are bearish in particular stock then opt to build bearish position as discussed below:

Buy out-of-the money put option and simultaneously sell out-of-the money call option in same stock for that month.

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While constructing above strategies, it can be observed we generally use the sale of one out-of- the-money put or call option  to fund the purchase of the counter options which makes this option strategy at zero cost. In these positions, you have potential to earn unlimited profit but there is equal risk of unlimited losses too (will be explained in example). However, you would not incur additional cost to enter in this position (apart from broker commissions).

Example

Assume, Microsoft Corp (MSFT) is currently trading at $30. The Feb 31 call option is quoted at $0.90 and Feb 29 put options is quoted at $0.90 on NASDAQ. The options lot size of Microsoft is considered as 100 shares.

Case 1:

If the prices of Microsoft are expected to rise then opt to buy out-of-the money Feb 31 call option and simultaneously sell out-of-the money Feb 29 put option.

Net cost = Cost of buying call option – selling of put option

= $0.90 – $0.90

= 0

In this case, breakeven price would be $31. This position would incur profit when the price of Microsoft stock rises above $31.

Case 2:

If the prices of Microsoft are expected to fall then opt to buy out-of-the money Feb 29 put option and simultaneously sell out-of-the money Feb 31 call option.

Net cost = Cost of buying put option – selling of call option

= $0.90 – $0.90

= 0

In this case, breakeven price would be $29. This position would incur profit when the price of Microsoft stock decline below $29.

Applying Zero Cost Strategy while hedging

Scenario 1

You own 100 shares of Microsoft which is currently trading at $30. The Feb 31 call option is quoted at $0.90 and Feb 29 put options is quoted at $0.90 on NASDAQ. Now you wish to hedge against fall in price of this stock.

Buy out-of-the money Feb 29 put option and simultaneously sell out-of-the money Feb 31 call option in Microsoft.

Net cost = Cost of buying put option – selling of call option

= $0.90 – $0.90

= 0

Net position = 100 shares of Microsoft + 1 option contract of Feb 29 put + short 1 contract of Feb 31 call

In this scenario, Feb 29 put gets hedged against a fall in stock price beyond $29. Also, this position would not gain value above $31 due to the short call options.

Scenario 2

You short 100 shares of Microsoft stocks which are currently trading at $30 and apply this position to hedge against rise in stock price. Its Feb 31 call option is quoted at $0.90 and Feb 29 put options is quoted at $0.90 on NASDAQ.

Buy out-of-the money Feb 31 call option and simultaneously sell out-of-the money Feb 29 put option in Microsoft.

Net cost = Cost of buying call option – selling of put option

= $0.90 – $0.90

= 0

Net position = short 100 shares of Microsoft + short 1 contract of Feb 29 put + 1 option contact of Feb 31 call

In this scenario, Feb 31 call gets hedged against stock price increase above $31. Also, this position would not profit below stock price of $29 due to the short put options.

Advantages of Zero Cost Strategy

  • Potential to earn unlimited profit
  • This strategy can be executed at “least” or “no additional cost”
  • An investor can use this strategy for hedging or speculating in equity, forex and commodity markets

Disadvantages of Zero Cost Strategy

  • Potential to register unlimited losses
  • Adequate margin required to take positions in both call and put options
  • Scarcity to get same strike prices for put and calls options and quoting at equivalent distance from particular stock price.

Conclusion

This strategy ideally incurs no cost upfront but requires adequate margin to enter in this position. Also, there is potential to earn unlimited profits or register unlimited losses in your account. So, you take timely calculated action while entering and exiting from this position. Say in case, if this position is profitable prior to expiration then opt to close both legs of this position individually at a right price.

About the Author: This article is written by Mayank Gupta from NineMillionDollars.com

BONUS FREE Download: 10 Point Graham Checklist to Help You Find the Best Value Stocks Anywhere in the Market today.
Highest scoring stocks on the checklist can deliver up to 50% per year return on average, according to one study. Are investment returns important to you? If Yes, than Download this Free today

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