Help a Noob, what's wrong with this easy money strategy?

Discussion in 'Options' started by 76132, Apr 24, 2011.

  1. 76132

    76132

    Ok, I'm completely new at options theory and trading (just picked up Natenberg's book and am reading it), so please bear with me.

    I was thinking about this strategy, and in my head it sounds like 'free' money. But obviously it's not free money because everyone would be doing it. So where's the fault in my logic? I can't figure it out.


    So I'm looking at the quotes on CBOE for Citigroup and this is what I see.

    -The last trade for the stock was at 4.55.
    -The ask price for a May 4.50 Put is 0.09.
    -The bid price for a May 4.50 Call is 0.13.

    With these prices, why can't you just simultaneously buy 100 shares of Citi, buy 1 put for 0.09 and sell one Call for 0.13. In other words you do a short combination.

    You make .04 net from the premiums and now you hold a riskless position. If Citi's share price goes up, you make money by going long 100 shares but you lose money from selling the call. If Citi goes down, your put offsets the loss.

    Easy money?

    Probably not? Please tell me why I am wrong.

    Thanks
     
  2. First of all, just for the record, that is not a short combination - short means selling both sides - in this example, you are buying one side and selling the other.

    You bought the stock at 4.55, but you are only protected at 4.50 - so while you would make .04 net from the premiums, you would lose .05 from the stock (either it falls below 4.50 and your put is now ITM or if it does stay above 4.55, you get called out of the position at 4.50 - in either event, you lose the 5 cents).

    So for all that stock buying, put buying and call selling, you lose .01 plus commissions, time and opportunity cost.

    JJacksET4
     
  3. Net cost of the position is $4.51 so you've locked in a loss of one cent (ignoring commissions and possible slippage if you have to exit on a pin).

    If stock goes to zero you get $4.50 for your put. If stock goes to 100 you give it up at $4.50 (the 4.50 strike covered call).

    No free money. :)
     
  4. When you do the "short combination", i.e. a synthetic short-position via the options, $4.50 + (0.13 - 0.09) equals an equivalent share price of $4.54. You're a penny "under" the market, $4.55, with your short-position, i.e. your locked-in loss of 1-cent per share. :eek: :( :mad:
     
  5. 76132

    76132

    Thanks guys. I get it now. I'd always lose 0.01 not including commission fees.