Aggressive Option Spread Trading: Vertical Spreads with a Naked Leg
The great thing about trading options is there are no limits to the number of strategies, or degrees of risk and reward. Depending on how an option strategy is structured, it can be a simple lottery ticket (buy a cheap call or put outright), a limited risk range trade, a premium collection effort, or a “free” trade in which the trader accepts theoretically unlimited risk for the prospects of a directional bias without any cash outlay. In this article, we’ll focus on the latter.
FREE Option Trades!
People love the idea of free, but most fail to acknowledge that the word free is typically synonymous with the phrase “strings attached”. When retailers offer free merchandise, they generally require you to purchase something else or perform some sort of task. A free trade is no different.
When you hear a trader refer to a free option trade he is speaking of a scenario in which an option spread trader pays an equivalent amount of premium for the long options of a spread, relative to the premium collected for the short options. In other words, it is a trade that requires no cash outlay because the premium paid and collected for each leg of the spread resulting in a wash. The strings attached to this type of free venture, is theoretically unlimited risk beyond the strike price of the naked short options and a margin requirement. Let’s take a look at an example of a specific type of option spread that can often be executed at “even money” (a free trade).
Bull Call Spread with a Naked Leg
A bull call spread with a naked leg is essentially the practice of financing the purchase of a vertical call spread with the sale of a put. If you aren’t familiar with the term vertical spread, it is the purchase and sale of two call options in the same market and month, but with differing strike prices. The buyer of a vertical spread would be purchasing the option with a strike price closer to the current market price (the expensive option), and then selling the option with a distant strike price (the cheaper option). The buyer of a vertical spread pays money to enter the trade, but the seller of the spread collects a premium in exchange for risk.