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Jeff note: This week, we're running a three-part series on advanced option-trading techniques. These strategies aren't for everyone. But they can vastly improve your results. If you're a serious trader, read on...

How to Trade for Free

By Jeff Clark
Thursday, May 3, 2012

Over the last two days, we've covered two of my favorite option trading strategies...
Selling uncovered (or "naked") puts allows you to collect money just for agreeing to buy stocks at a discount. It's the best income-producing trading strategy in the world.
Spread trading will lower your risk and can shift the odds dramatically in your favor.
Today, I'm going to show you something even more impressive: A butterfly spread is an option strategy that, when done right, costs nothing... yet it can be enormously profitable.
There's no easy way to explain it other than to dive right in with an example. So here goes...
Yesterday, we worked out an example of a spread trade on Arena Pharmaceuticals (ARNA). If you missed it, I suggest you go back and have a quick read.
In short, an FDA advisory committee is reviewing Arena's weight-loss drug, Lorcaserin, next week. A negative review could crush the stock. But approval could send ARNA shares soaring.  
I'm guessing ARNA could pop 60% or so from $2.15 all the way up to $3.50 per share. (This might not reflect ARNA's current price. But this example is just for illustration. To be clear: I'm not recommending this trade.) 
In my last essay, I structured a call spread that cost us only $0.14 and gave us the potential to make $0.36 if Lorcaserin wins approval and ARNA shares reach our target price of $3.50 per share.  
This is a good-looking trade, but we can make it even better. And bear with me. There's some math. But it'll be worth your time...
Think about this... the only way we'll profit off this spread trade is if Lorcaserin gets approved and ARNA rallies above $3.14 (the breakeven for the position). If the FDA gives Lorcaserin a thumbs-down, ARNA shares will get crushed and we'll lose $0.14. We'll also lose money if Lorcaserin gets approval but ARNA doesn't rally above $3.14.
We lose money because we had to pay money upfront to establish the position. But what if it didn't cost anything to get into the trade?  
If we don't spend any money up front, we won't lose anything if Lorcaserin doesn't get approved and the stock falls. We also won't lose anything if Lorcaserin gets approved but ARNA doesn't rally as much as we think it should.
In other words... it's a lot harder to lose money being wrong on a free trade. The trick, of course, is figuring out how to make it "free." That's where the butterfly comes in handy.
Here's how a butterfly spread would look for ARNA options based on the recent prices...
Month & Strike 
May $3 call 
May $3.50 call 
May $4 call 
Total net cost 
Please note: each contract covers 100 shares 
Let's walk through each piece... 
Just like in yesterday's spread example, we're buying the ARNA May 3 calls. We're betting that the stock moves over $3.  
We're also selling the ARNA May 3.50 calls. This is a bet that ARNA won't rally over $3.50. This time, though, we're selling two of these calls instead of one. We'll collect twice as much option premium and more than cover the cost of the ARNA May 3 call option.
Selling the extra option, though, leaves us exposed to excessive risk if ARNA rallies well above $3.50 on the news... To offset that risk, we spend the extra premium to buy one ARNA May 4 call.
The largest profit occurs if ARNA rallies to $3.50. Our ARNA May 3 calls will be worth $0.50 and the other options will expire worthless. So we'll have a $50 profit on a net cost of $0.
Since we managed to structure this butterfly spread for a net cost of $0, we can't lose money if ARNA falls or if it doesn't rally above $3.
Above $3.50 per share, however, we start to give some of that profit back. At $3.75 per share, the position is back to breakeven. And at $4 per share, we would actually lose $50 on the trade. But that's our maximum loss.
What we've created here is a trade that doesn't cost anything to get into. We won't lose money if ARNA doesn't get approval for Lorcaserin and the stock falls. We'll make money if the stock rallies anywhere between $3 and $3.75 per share. Our maximum profit of $50 is hit at our $3.50 price target for the stock.
We start to lose money if ARNA rallies above $3.75. We'll suffer a maximum loss of $50 on this trade if the stock rallies to $4 or above.
This butterfly spread increases the probability of a profit on this trade at multiple price points. It also eliminates the risk of a loss if we're wrong and the stock takes a hit. The only risk is if the stock rallies beyond where we think it will on good news.
A butterfly spread is just another option strategy designed to reduce risk and increase the probability of a winning trade. It works best when option premiums are inflated and you can structure the position for free or – better yet – for a net credit to your account.
I know this is a lot to cover in one essay... But I guarantee if you get the hang of this, you'll end up taking on less risk... and making more money.
Best regards and good trading, 
Jeff Clark

Further Reading:

Earlier this week, Jeff showed readers one of the best income-producing strategies in the stock market. If you listened when he recommended this strategy last year, you could have earned 14.3% on one stock in just 10 months... while common shareholders lost almost 40%. Click here to learn more about this "no brainer" strategy.
And yesterday, Jeff introduced a way to reduce the risk of an option trade and increase your chances of booking a winner. Learn more here.

In The Daily Crux
Market Notes
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