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The Free Option Position is a directional trade that allows you to purchase an option with the premium received from selling other options. It is a good position to use when the trader expects a directional move, and sees strong technical support or resistance levels to trade against. The Free Option Position is appropriate for situations where there is higher implied volatility in out-of-the-money options than those near the market.
The Free Option Position normally involves buying a near-the-money option, and selling an out-of-the-money call and put. For a bullish trade, the position would be long a near-the-money call, and short an out-of-the-money call and put. This results in a bull call spread combined with an unhedged short put. For a bearish trade, a near-the-money put is purchased, and an out-of-the-money put and call is sold.
The Free Option Position can make good gains if the market makes a directional move as expected. Even if the market just stays near the starting price, there would be no loss, if the trade is initiated with no entry cost. However, if the market moves significantly against the position, traders should be quick to close or adjust the unhedged short option, which can give unlimited losses. Although this trade has limited profit potential (the value of the vertical debit spread), and unlimited loss potential (the unhedged short option), it can be appropriate when market conditions are right. As in all trading, it's important to use proper money management to control potential losses.
An example of a Free Option Position in Soybeans:
In the summer of 2003, Soybeans were declining during July in a typical pre-harvest slump. They moved down to test a support area from previous lows in the 500-510 range. At that point, they started to stabilize for about 3 weeks. This would give traders confidence that the previous support area was going to hold, and the market might have upside potential since there was already strong global demand, and the crop might not come in as large as expected.
For this specific example, November Soybeans closed at 512-3/4 on August 5, 2003. With the market stabilizing, traders might have considered the following Free Option Position: Buying the November Soybean 520 call (near the money), and selling the 560 call and 500 put (both out-of-the-money). The 520 call settled at 16-1/8 cents, the 560 call at 5-1/2 cents, and the 500 put at 13 cents. So, the settlement prices showed the position at 2-3/8 cents credit. In other words, the premium from the options sold was 2-3/8 cents greater than the option being purchased. So there was a net premium gain from entering the position. There was no capital tied up in purchasing options, but there would be margin required to enter the trade, due to the unhedged short put option.
When the trade is first initiated, the trading plan should include a stop-loss plan, either for the value of the whole position, or a stop on the unhedged short option. With the position based on the outlook that the 500-510 support range was going to hold up the market, a trader might have decided to stop out if the market closed below that area.
A few days later, Soybeans started their spectacular mid-summer rally, as concerns about crop size and increasing demand drove the market to higher prices. In less than two months, at the end of September, November Soybeans had moved up to test the $7.00/bushel area. With the long call spread deeply in the money, and now trading at full value of 40 cents, the position could have been closed. Total gains would have been about 42 cents, including the credit received when the trade was started. That's a $2100 gain for a position that had no entry cost, only an initial margin requirement.
In the Soybean example, some observers might comment that much bigger gains could have been made with other strategies in this market, since Soybeans made such a big move. Well, we can always pick the best strategies with the benefit of hindsight, but given the market outlook at the time, the Free Option Position was a good choice. Once the market started to show significant technical strength and fundamentals started to turn more bullish, a variety of other strategies could have been used to add to potential gains during the Soybean rally.
Chart example: Profit/loss analysis for typical bullish Free Option position:
