Reducing Downside While Keeping the Upside

10/04/2012 8:00 am EST


Steve Smith

Reporter (Options Columnist), Minyanville

Steve Smith shares an option strategy that combines low cost and limited risk with big profit potential.

Most option strategies hope to use the leverage of options to limit risk, increase the probability of profitability and ultimately deliver returns that (on a percentage basis) are better than just owning stock. But there is usually always a trade-off: Risk can still be 100% of the investment, or more in naked sales, and returns can be lower than expected if the timing of a move doesn’t align with the expiration date.

One strategy that combines the above attributes is the risk-reversal. A bullish risk-reversal consists of being long (buying) an out-of-the-money call and being short (selling) an out-of-the-money put, both with the same expiration date. A bearish risk-reversal can be established by selling the call and buying the put. The low cost is achieved since you are using the sale of the put (call) to help finance the purchase of the call (put). A risk-reversal position simulates the behavior of a long (or short) position in the underlying shares. Therefore, it is sometimes called a synthetic long (or short) position. It is a great strategy to use for a stock with a well-established trendline, such as TJX Companies (TJX) or big chips like McDonald's (MCD) and IBM (IBM), which are supported by dividends.

For example, let’s look at a basic risk-reversal in the SPDR 500 Trust (SPY). With shares trading around $144.80, one can buy the November $146 call for $2.25 per contract and sell the November $143 put for $2.20 per contract. This is a net debit of just $.05, which means that even if shares of SPY drifted lower, but remained above $143 at expiration, the position would only lose $5 per each risk-reversal (buy one contract, sell one contract).

The position’s delta is 0.85 or the equivalent of being long 85 shares of the SPY. This is calculated from the fact that the short put has a 0.40 delta and the long call has a 0.45 delta. Add them up and you get 0.85. As shares move higher, this will increase as the delta in the long call will gain more rapidly than the decrease in the short put.

A position of long 85 shares of the actual SPY would cost $12,380; even with 50% margin, it would require a $6,190 outlay. But note: It would be misleading to compare this to the $5 cost of the risk-reversal because the risk-reversal has a naked option component—in this case, the short put—and will have a margin requirement appropriate to the possibility, however remote, that shares could go to zero.

Check with your broker for particulars, but a general rule is that for broad-based index positions such as the SPY, you must post margin to cover a 10% move. For the above SPY position, that will be around $2,700; less than buying shares outright, but still substantial. Individual equities are stressed at 20% price move. [Editor's note: The rule of thumb is that brokerage firms will run a test of what would happen to an option position if the stock suffered a 20% decline, gauge what that loss would be, and base the margin requirement on that amount. This is reset every day. So if a stock declines 5% one day, you will likely have to add more capital to maintain the position the next day. This is the infamous "margin call."]

With that in mind, let’s move on to how we can reduce our risk, and therefore the capital required to establish such a position, while still maintaining unlimited profit potential.

NEXT PAGE: Reducing the Risk Portion


Reducing the Risk Portion
In order to limit the risk, I’m transforming the "naked" portion of the position into a standard vertical spread. Let’s look back at our SPY position. Instead of selling that $143 put naked, now also buy the $141 put for $1.60 per contract. We have now created a bullish put spread for a $.60 net credit.

This limits the risk to the downside. So the overall position looks like this:

-Buy one Nov. $141 put at $1.60

-Sell one Nov. $143 put at $2.20


-Buy one Nov. $146 call at $2.25

This is now $1.65 net debit for the position (pay $2.25 for call minus the $.60 collected from put spread). While this is significantly higher than $.05 debit of the pure risk-reversal, the margin requirement will have dropped from around $2,700 to just $450 since that is your maximum loss if shares of SPY are below $141 at the November expiration. This means that on a percentage basis the returns will be substantially higher.

Now the position starts with a delta of 0.52 or equivalent to being long 52 shares. But remember: Even though we have substantially reduced the risk to the downside, the upside potential is still wide open. This seems like a good trade-off.

by Steve Smith, Contributor, Minyanville

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