Option Trading: Arbitrage in Spreads.
Arbitrage
The term “arbitrage” has different meanings depending on context. In financial circles the reference is frequently to a situation where the up front reward is greater then the risk, so it’s always a win.
Probability of success
Option trading is a mathematically balanced system where in general higher risk generates greater reward but with a lower probability of winning the reward. The phrase high probability trading comes from trading strategies or philosophies which dictate you trade only high probability of success trades with smaller, but more certain rewards. In general when I set up a high probability trade I usually seek to get a credit of 1/3 the spread between the strikes. So this means for 5$ spreads around $1.65 and for 1$ spread 33 cents. Very rarely I may find a spread where the credit is larger then the spread. In such an instance a reward is guaranteed.
Guaranteed Winners
If I find a spread where the credit is larger then the spread. In such an instance a reward is guaranteed. This is rare, but this is what it looks like;
I sell a call contracts 5 points above market price. Gross credit $6.15
I buy a call contract 5 points above my sell price for $1.00, net credit $5.15 or $515
My risk is the spread 5 points or $500 minus my credit which is $515, which is negative $15. So even if I am wrong and I have to pay the whole $500 spread I still make $15.
Iliquidity
These are rare and the wide spread suggests illiquidity, meaning the strikes are rarely traded. Which is usually a reason to avoid trading those strikes. Normally you need to trade in and out of positions to profit, but in this case the liquidity is low, so you may have trouble getting in to the trade. I know sone of you are probably thinking that with a guaranteed credit greater then the risk you want to trade 100 contracts Unfortunately, the low liquidity means very few contracts will be traded and your lucky to get 1 or 2 contracts, great if you can get 10.
Remember
But remember bears get rich, bulls get rich and pigs get slaughtered.
Don’t be a pig.
✍️ written by Shortsegments
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