I'm beating a dead horse on Twitter. I'm beating it here. Why? Because today, you're seeing something you virtually never see in the markets. Ever.
The options market is so mispriced in the July far out-of-the-money put contracts on GameStop (GME) that you can lock in a risk free rate of return in the 20% to 40% range between now and July.
Now, how can something risk-free have a stated rate of return? I'm glad you asked. The reason has to do with buying power.
We're going to use an example. In this case, I'm talking about the July 21, 2021 GME $3 - $2.50 - $2 put butterfly.
In this trade, you would be long one $3 put, short two $2.50 puts, and long one $2.00 put. That leaves you long two puts and short two puts. Your risk on that particular trade is only what you pay for it, but there's a catch in buying power.
The trade is divided into a long put spread $3 - $2.50 and a short put spread $2.50 - $2.00. That short put spread will tie up $50 in buying power plus your cost. So, despite your risk being limited to your entry price, there is still a buying power tie up. Ironically, this later swung to the $4 - $3.50 - $3.00 for the optimal return, so a trader could have double-dipped.
This is where today gets interesting.
This particular trade has been paying a NET credit. Remember, our risk was our cost to enter; however, we're getting paid to enter. That means our risk is actually greater than zero. The worst-case outcome is the net credit received upon initially making the trade.
Let's walk through this screen shot, above.
Here, we can buy the $3 put for $51. We then sell two $2.50 puts for $50 each, bringing in $100. Next, we buy the $2 put for $40. Overall, I spent $91 ($51 + $40) and I collected $100. That's a $9 net credit. This impacts my buying power $50 less than $9 received, so $41 overall. That means, between now and July, I will make a return of $9 on my $41, or 22%. If the stock falls to $2.50 (doubtful), that could increase to $59, but as long as I close this upon expiration, I'll walk with $9 less commissions.
Around lunchtime the $4 - $3.50 - $3 put butterfly paid a net credit as high as $20! So, $20 against $30 of buying power and now risk. I'll take a 66% risk-free rate of return in six months anytime.
The key point is what to look for in this scenario. I mean, telling folks about the trade after-the-fact does little good, so how do you spot these?
For now, I'm looking at the option chain. What I want to see is a skew. In this case, I noticed the bid price on the $2.50 put was very close to the ask price on the $3 put. They were only a penny apart. While the bid on the $2.50 was a dime above the $2 ask. Normally, this is reversed. So, when I see the top number (the red number "10" I've drawn) is bigger than the bottom number (the red number "1"), I immediately know I want to go after this trade.
That's the math you need to do. You're looking for skews like the one here. It takes a little practice. The tighter the butterfly, the easier it is to see with the naked eye. In this case, they are all one strike apart. If you try to look at the $5 - $3 - $1, you have bigger numbers to deal with and more strikes in between. It's easy to make a mistake. Think of it like climbing a ladder. It's easy to go one step at a time. The more steps you try to take, the more prone you are to an accident.
In short, what you are looking for is the ask on the highest priced strike to be close to the bid on the middle strike and the bid on the middle strike to be much larger than the ask on the lowest price strike. I circled them above. When I see 0.51 - 0.50 - 0.40, you can see it stands out. This we want! The difference between the first two numbers is significantly less than the difference between the last two numbers.
If it were 0.51 - 0.41 - 0.40, you wouldn't touch it. Here the difference between the first two is greater than the difference between the second two. At that point, you'd pay $11 for the put spread rather than pay $10 for a butterfly.
I'm not arguing this is an easy concept to do with the naked eye, but it is doable.
One other thing to consider: You may have to leg into the trade, which means doing all the strikes individually. That is a definitive risk. In that event, I do them pieces at a time and will try to have orders ready at the same time. This is why I focus on using the bid and the ask. As long as I don't try to oversize or stuff my entire position at once, I should get execution. I might even get better execution than the ask on the buy and the bid on the sell, but if I price based on the bid-ask and I still have some cushion, then I should walk away with a winning strategy.