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Opportunities In Options
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The Free Trade combines the best principles of money management and the advantage of "undervalued" and "overvalued" options; however, the most exciting aspect of the free trade is that it allows you to build a large position in a trending market without increasing your initial risk.
The "FREE TRADE": A Quick Introduction
The Free Trade is used in trending markets to purchase options of low to medium volatility that are close to the money (particularly on pullbacks or reactions against the trend). Farther out-of-the-money options which can have much higher volatility levels are sold on rallies to complete the Free Trade.
To initiate the free trade, first purchase the best-priced option. When (and if) the price and volatility (premium) rise, sell a further out-of-the-money option at the same price. Of course, if the market does not move in your favor, you cannot complete the free trade. Another benefit of the free trade is that after it is completed, there is no margin capital necessary or potential loss (other than brokerage fees and costs). For example, in February 1994 in bonds, you could purchase the 112 and 110 puts. Thereafter, the market continued to decline and you could sell further out-of-the-money options, such as 106 and 108 puts at the same price as we purchased the 110 and 112 puts.
For example, if you purchased the 112 put and paid 32 ($500) and thereafter sold the 106 put for the same amount, you would then have a position that had a net cost to you of $0 (except for commissions and fees) and a profit potential of $6,000.
The free trade accomplishes several objectives: First, it keeps your account intact if the market turns around. Just as quickly as markets rise, they can also fall. The free trade position provides protection from loss in this situation.
Second, if the market moves in your favor, you can continue to add to your position on the next pullback. If the trend remains intact and the market pulls back, as it eventually will, you are then in a position to purchase another option to begin building a larger position. You can look to turn the second position into a free trade using the same method without increasing your initial risk. By doing this you can take advantage of the normal swings of the market to purchase options when they are the cheapest and sell them when they are the most expensive, on rallies. Further, you will be purchasing "closer-to-the-money options" which are normally the most fairly valued options, and selling "out-of-the-money" which are usually the most overpriced options.
Another benefit of the free trade is that it gives you time to unemotionally examine your position without the panic other traders experience as their profitable positions begin to nose-dive. Because you are protected, you can wait for emotions to subside and the market to give you a better indication of its next move. You can then decide to hold your position and look for full profit potential (knowing you are completely protected from loss), or you can cash out and take your existing profits.
The final benefit of free trades is that, when they are completed, because your capital is protected, you can turn your attention elsewhere. You may find opportunities in another commodity, or even in the market in which you have completed free trades to add more positions. This can be accomplished without increasing your original risk because your first positions are now risk-free! It is difficult to closely monitor more than two or three net positions, especially in volatile markets. The free trade allows you to concentrate more fully on other situations.
The free trade also allows you to meet your objective of getting a "trading edge" over the markets by using options. You are taking advantage of the increased volatility of the out-of-the-money options, which can be quite exaggerated on market rallies.
