No risk equity option trade by John Carter

The “No-Risk” Trade This trade is one that pairs a futures option with a futures contract to create a “no risk” trade IF you are filled on both the option and the future. If you do not get the fill on the futures contract, your risk will simply be the amount you paid for the option which is generally about $150.

TRADE SETUP: This trade is designed to be used on Friday mornings. Since futures options expire each week, there will always be an option expiring at the end of that day.

Select a direction for your trade. For the first example, we will assume that you have a short bias.

Using the chart on the following page, we will use an example of the S&P futures (/ES) opening at 1543.75 at 8:30am CT. Within the first five minutes of trading, the ES reaches 1545.

To start the trade, you first buy the futures option. The price you pay for this option will be your maximum loss for this trade. You want to buy an AT THE MONEY option, meaning the strike where the market is currently trading.

Since we want to be SHORT the S&P futures, we will be buying a CALL option to protect ourselves.

Generally, at the money options in the S&P trade for about 3.00 points ($150) the morning of Friday expiration.

So at 8:35am CT (or any time that morning that you choose) we buy the /ES 1545 call option for 3.00 points. Since futures options trade in points of their respective instrument, this will cost us $150 (3 x $50/point).

To create the “risk free” trade set up, we then need to sell short an S&P futures contract at the price of the strike PLUS the number of points we paid for the call option. In this case, we would place a sell limit order on the /ES at 1548.00 (1545 strike + 3.00 points we paid for the option).

At this point we have a risk free short position (not including commissions) with unlimited profit potential and no risk – regardless of what the market does between now and the 3:15pm CT close.

Let’s examine what we have created.

Our 1545 /ES call option now has 3.00 points of intrinsic value, meaning we could execute it for a 3 point gain. We also have a short position on the underlying futures contract from 1548. Since the option is now in the money, the call option will earn a dollar for every dollar lost by the /ES futures contract.

If the /ES shoots up 10 points, we will lose 10 points on the futures contract but make 10 points on the option. So any move higher will result in no loss or gain since these positions offset each other’s gains and profits.

Now, if the market goes DOWN, this is when we begin to profit. Remember that this was our original bias. We wanted to be SHORT the market with unlimited profit potential for a down move. So let’s examine what happens there.

If the /ES futures go DOWN 10 points, what happens? Our futures contract will make 10 points ($500).

But these gains will not be taken away by the call option. Since we are long the call option, the worst thing that could happen is the option goes to zero and expires worthless. The 3 points we paid for that option ($150) will disappear but that is the most it can take from our profits on the futures contract.

So if the ES closes down 3 points from our entry at 1542, our trade will result in no profit - $150 loss on the call option we bought and $150 gain on the futures contract. If it falls MORE than 3.00 points, everything past that is profit.

A close at 1530 would result in a $600 gain. We would of course lose the $150 on the call option we bought. A 1545 call will be worthless at the close if the market closes at any price below 1545. But the futures contract will have a 15 point profit. $750 gain on the futures contract (15 X $50) minus the $150 we lost on the long call option will create a net profit of $600.

Below is a chart of that situation. It is a 5-minute chart of the S&P futures from the 8:30am CT open through roughly noon. Note that it took almost two hours to get filled on the futures position. However once filled, you are in a risk free trade and any move below 1445 is free profit for you until the end of the day.

Settlement: A lot of people ask about how to close this trade out, so let’s go over each scenario and what will happen with each. /ES ABOVE 1458 – any close above 1458 will leave you in a no loss/no gain trade. You own a 1455 /ES call and are short the /ES futures from 1448. When the options are settled at the end of the day, you will be assigned a LONG /ES futures contract with an entry price of 1445 in exchange for your 1445 call.

Since you are already short the /ES futures from 1448, this will act as a closing order and leave you flat of all position. You will have $150 profit from the net futures trade minus the $150 you paid for the options leaving you with nothing lost and nothing gained. You do not need to do anything to close these positions out although you are free to do so. Just be sure to both buy to close the futures contract and sell the close the futures call option. /ES BELOW 1455 – This will depend on whether or not you were filled on your futures contract.

If you bought the 1455 call option but DID NOT get filled on your /ES short from 1458, there is nothing to do except to cancel your sell limit on the /ES at 1458. Since your only position is a now worthless 1455 call, it will simply expire worthless and you will lose the $150 you paid for it. Bravo for calling the right direction for the market on the day though. Sometimes we just don’t get the fill.

If you DID get filled on the short /ES futures contract at 1458, you fulfilled the no risk trade. Any close below 1455 will represent a profit in the amount of $50 times the number of points below 1455. The call option you bought will expire worthless since we are below 1455, so no need to close that out. You DO need to close out your futures position though. You have nothing to offset it so you will want to take profits. The futures market closes at 3:15pm CT so enter a Sell-To-Close order on the /ES futures contract that you sold short at 1458 and enjoy your profits. /ES BETWEEN 1455 and 1458 – This one is a little trickier, so let’s walk through it.

If you DID get filled on the /ES short at 1458 then you have a no risk trade on. You will lose a little bit on the call option and make a little bit on the futures contract resulting in a no loss/no gain trade. Since the call option will result in being assigned a long /ES futures contract from 1455 and you already have a short /ES future from 1458, these trades will offset each other and leave you flat with no open positions.

Technically there is nothing that needs to be done here. However, since the last few minutes of the market can be volatile, I suggest that you close out both positions before the market closes. Simply BuyTo-Close the /ES futures and Sell-To-Close the 1455 /ES call option. You may lose a few ticks by entering market orders but it is better than a last second selloff leaving you with an unprotected short position going into the weekend.

If you DID NOT get filled on the /ES futures short position at 1458, then you are only holding a long 1455 /ES call. At the end of the day, this option will be worth however many points it is above 1455. Simply enter an order to Buy-To-Close the call option and cancel the sell limit order on the /ES futures at 1458.

You will have a small loss of less than $150.

A few things to note: 1. Whatever you pay for the option will be your maximum risk.

2. The trade is only “risk free� if you get filled on the corresponding futures contract.

3. With this trade, you will never lose money if you choose the direction WRONG. Since the market has to move roughly three points AGAINST the direction of your trade to get filled on the futures contract, if you are dead wrong you will always get filled and have no risk.

4. The only way you will lose money on this trade is if you pick the direction correctly but the market does not wiggle 3 or so points in the opposite direction to get filled on your futures contract. Again, you risk is limited to what you paid for the option. This is why I prefer to take this trade early in the morning session so that I have the best chance of getting filled on both sides.

5. The only way that these trades offset each other in the previous settlement examples is if they are done in the same account. If you do them in separate accounts, be sure to close out each position before the end of the day.

6. Unlike stock options, futures options only represent ONE futures contract. So if you buy one call option, sell one futures contract. If you buy five, sell five. The ratio is 1:1.

7. This trade will also work if you want to play the long side. To adjust it, simply buy a put option first, then let the market go DOWN by the number of points you paid for the put and buy long the /ES futures contract. All of the previous settlements will work in reverse.