Question
If a stock is trading at $25 and I sell the December 7.5 calls and buy the December 17.50 calls for a net credit of $10, I can’t lose money. The spread will always be worth $10 (the difference in the strike prices) and if the stock goes below $17.50, I will make money because I can buy the spread back for less than $10. Is the risk associated with assignment or am I missing something.?
Answer
On the surface you appear to be right – this is a riskless trade. You also nailed one of the two problems with your trade – assignment. The December 7.50 calls on a $25 stock are probably trading at a discount. That means that you will have to accept something less than $17.50 when you sell them. The Market Maker is in this to make money. He will buy the option for $17.40 and sell the stock at $25. He will then exercise his right to buy the stock at $7.50. In doing so, he will make $.10 on the transaction. He will also start a domino affect on any open interest on the December 7.50 calls. If the open interest is you, you will be assigned overnight and you will come in the next day short the stock at $7.50. The best thing you can do is to exercise your December 17.50 calls and come to the realization that you will be caught in a vicious circle if you continue to reestablish the spread. As it stands you will only be out two commissions on the way in and two commissions on the way out.
A second problem with your trade is that you will NEVER find a Market Maker that is willing to sell you that spread for $10. They have no upside to that trade. Since the options are in-the-money, they will widen the bid/ask so that they can dictate the credit or debit for the trade. In doing so they can decide how much profit they want to build in to a virtually risk-free trade. They might be willing to buy it for $9.70. The extra $.30 needs to yield a better than risk-free rate of return (T-Bill) for them to have any interest. Even at $9.80, you still run the assignment risk and now you will add a $300 loss to the commissions mentioned above.
You could try to leg into the spread, however that is very risky. Now, you are trying to execute an arbitrage trade against Market Makers who have auto quote systems.
I suggest you look for directional trades. Leave the arbitrage and neutral strategies for the big boys. You won’t find an edge there.
