Tell me why this doesn't work

Discussion in 'Options' started by jftrader, Mar 7, 2012.

  1. jftrader

    jftrader

    So here’s the scenario that I have in my head. It seems so simple which is why I’m sure it won’t work, but I would like to be educated as to why. Why can’t you sell the same # of contracts of uncovered Calls and Puts at the same strike price (near or slightly in the money but it shouldn’t matter) and hold until expiration.

    Possible Outcomes
    1) Market rises & call exercised: Put expires worthless and you keep the premium, call is exercised so you have to buy the stock and then sell it for a loss, loss is completely or partially covered by the premiums of selling the options
    2) Market rises and call not exercised: Keep both premiums
    3&4) Same as above but with the market falling instead of rising

    As an added protection if the stock price moves more than what you have made by selling the options why can’t you close out both options postions at that point. In theory the change in intrinsic value of the calls and puts will offset each other and you will be left pocketing the time decay of each.

    So why won't this work? Intrinsic values won't actually offset like this?
     
  2. It won't work because you are taking unlimited risk that the stock will run away from you in either direction, maybe your broker doesnt allow this?
     
  3. - What you are describing here is a "short straddle", where you sell equal number of calls and puts at the same strike price. I sell these every month but unfortunately it is not free money and I am not yet retired.

    - Your risk is that the underlying moves more than the total option premiums you received. To use your examples:

    1) If the call is exercised you will be SHORT the shares at the strike price, not long. You will have to buy the shares back at a loss. This loss may or may not be covered by the original premium received.

    2) If the call is in the money as you described it WILL be exercised at some point, most likely at expiration. It's not like people forget to exercise and you get to keep all that free money.

    3&4) Same as above.

    "As an added protection if the stock price moves more than what you have made by selling the options why can’t you close out both options postions at that point."

    - You can close out both options but at a guaranteed loss.
     
  4. I'll make it simple for all of you:

    Just use Call-Put parity.

    Problem solved.
     
  5. Not a problem if the stock moves less than the premium received (on an expiration basis). But what happens if the stock moves 2x? Or 3x?

    Prior to expiry, losses accrue on any early move. It's possible to never see break even.
     
  6. What a way to destroy someone's dreams. I thought I had encountered the holy grail of trading.:D