Option Investor
Educational Article

Are There Any Free Trades\?

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Are there such things as totally free trades? What do you believe? Of course not. Except, of course, for those of you who still believe in the Easter Bunny or that George Bush has a clue. Then, anything is possible.

But there are ways to reduce your out of pocket risk to almost zero. This is not complicated. Actually, its pretty easy and it will also give you a chance to put some real money to work out there in that big casino we call the market.

A lot of people suggest that you should virtual trade or paper trade before trading with real negotiable dead presidents. Its actually a good idea. Virtual trading will give you a chance to learn the mechanics of the trading process, and even get a feel for managing a trade.

There are some quality online brokers out there who have excellent virtual trading platforms. These platforms can actually simulate the actual fills at current market prices -- as though it was a real order. Its great practice. But its not the real thing.

For all the positives about virtual trading, there is one undeniable fact. It will never be the same as risking your green, spendable hard-earned dollars. Virtual trading is like using Monopoly money. You start out thinking its real. Thats all well and good until its time to make an important trading decision. With Monopoly money, that little voice inside of you says, what the hell, lets hold on. Itll come back. Or, theres more profit in this trade. I just know it. The problem is, you listen to the little voice and hold the trade too long. The Monopoly money disappears and you tell yourself that you will act differently when youre trading with real money. Its the kiss of death.

Thats the worst trading habit to develop. It will cost you big time. Maybe not on the firs trade, or even the second trade. But, take my word for youre your luck will run out. Youre cruisin for a financial brusin and it wont be pretty. Its the first step toward shopping for your next wardrobe at the Salvation Army.

The one hard and fast rule you need to follow in trading is that you need to know your exit points -- even before you put on the trade. And, more than just knowing the exit points, you have to have the self-discipline to make the trade at the appropriate time. Its not like the 10 commandments where you can pick and choose which ones you want to follow and just confess about the ones you didnt follow. Were talking real money here. This is serious.

We got off on a bit of a tangent here, but virtual (or paper) trading plays an important role in the learning curve for new option traders. Now, lets get back to setting up the free trade.

a) Simply buy a bank guaranteed CD. Since the interest rates have been rising, at this writing 90-day bank CDs for 5% are pretty common. Another alternative is to use 90-day US Treasury Bills, currently yielding about 4.8%.

b) Then, you use the interest from these assets to pay for some inexpensive out of the money options on the asset you have chosen. To make the best use of your money, you may need to use an option spread. Well get into spreads in depth in upcoming columns. A spread consists of buying one option and selling another. It can substantially reduce the amount you have at risk. In brief, the premium you receive from the option you sell lowers your out-of-pocket expense. In exchange for the lower costs, using a spread limits your upside. But, theres still plenty of room for profit.

For example, XYZ company is trading at $42. For whatever reason, you believe it will move significantly higher in three months. A speculative spread might consist of buying a $50 call for $1.50 and then sell the $55 call for $.35 a net debit of $1.15. You might be able to afford a 2-3 contract position (depending on how much you put into the CD).

Your profit potential for this spread is over 350%. XYZ will have to close over $55 to achieve that kind of profit. Thats a huge move. Is it likely? No. Is it possible? Yes.

Ideally, you would put on this kind of position when implied volatility is low. Low volatility translates into lower costs. Lower costs equals more room for profit.

So, you now have an option position a real one. Its likely pretty far out of the money. Look at it like a lottery ticket. If you guessed right on the direction, you may walk away with a nice chunk of change. And, what did it cost you? Nothing.

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Hey, this is good stuff - especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money - and they're still making money to this day. I hope you'll become one of them.

Who Is This Guy? --
Mike Parnos has "been there and done that" - plenty! Known as the MasterTater and "Options Therapist," Mike has been writing the profitable and popular Couch Potato Trader column (for OptionInvestor.com) for almost five years. Hes been trading, consulting and teaching option strategies for over 12 years and now manages a hedge fund. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Have questions? Contact Mike Parnos at Contact Support.

For serious option traders, Mike also offers a comprehensive advanced two-day seminar covering many fascinating and profitable non-directional strategies.

Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
 

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