A Reversal of Fortune Option Strategy
03/17/2014 8:00 am EST
Steve Smith of Minyanville.com offers an aggressive strategy for times when you might feel there is a very, very attractive entry point that presents the potential for a strong counter move.
Traditional spread option strategies such as calendar spreads, butterfly spreads, and iron condors allow you to reduce costs in exchange for capping gains. In this article, we’re getting more aggressive and drilling down into a strategy known as the risk reversal, which uses combinations of puts and calls to create a low-cost position that carries both unlimited risk and reward.
A 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.
What makes the risk reversal different from most leveraged speculation or hedging strategies is that it aims to achieve a position with a very strong directional bias, but with a minimal capital outlay or possibly even a credit.
When constructing a risk-reversal position, the sale (purchase) of the put should offset the cost (credit) of the call.
A risk-reversal position simulates the behavior of a long (or short) position in the underlying shares. Therefore, it is sometimes called a synthetic position.
For example, if we wanted to make a bullish bet on IBM (IBM), with shares trading around $205, we could:
- Sell the May $200 put for $3.20 a contract
- Buy the May $210 call for $2.50 a contract
- This gives us a $0.70 net credit ($3.20 - $2.50).
So, if IBM shares simply remain above $200, or do no worse than a 2.4% decline before the May expiration, the position will reap a $0.70 profit.
This risk reversal requires much less capital, even on a margin account, than buying underlying shares outright. The flip side is that if IBM only goes go up $210 at expiration, the profit will still only be $0.70, as both the put and call will expire worthless.
Of course, the ideal scenario would be the stock skyrocketing, as the call option will increase in value, while the put will be worth less—creating unlimited profit potential. Note, however, that there is also significant downside risk if IBM’s stock were to collapse. In that case, the value of the short put option would dramatically increase while the long call would be crushed.
NEXT PAGE: Reducing the Risk Portion|pagebreak|
Reducing the Risk Portion
As shown in the above example, because a pure risk reversal involves a naked short or uncovered sale of an option, it carries enormous downside risk. Again, this is no different than being long or short a stock, but my goal as an options trader is to gain the benefit of leverage but keep risk limited.
I do this by transforming the “naked” portion of the risk-reversal position into a standard vertical spread.
Sticking with the IBM example above, we could expand the position by going long the May $195 put, giving us the following combination:
- Buy the May $195 put for $1.90 a contract
- Sell the May $200 puts for $3.20 a contract
- Buy the May $210 call for $2.50 a contract
This gives us a $1.30 net credit ($3.20 - $1.90) for the put spread, meaning the total position has now shifted to a $1.20 net debit. Note, we get $1.20 by subtracting the $1.30 net credit from the cost of the call, which is $2.50.
This puts the breakeven at expiration in the $199.30 to $211.20 range.
The breakeven points are calculated by adding (or subtracting) the net debit (or credit) to the risk-reversal strike prices. So when we received a $0.70 credit, the $200 put would be $0.70 in the money, making $199.30 the lower breakeven point. When we shift to a $1.20 net debit, it will take a rise above $1.20 above the $210 strike, or $211.20. Just remember these numbers are based on the expiration date, and profit and losses could change if the position is exited before expiration.
Using a spread on the put side caps the loss to $4.90 should disaster strike and IBM take a big dive below the $195 level. The upside, however, is still potentially unlimited as we remain outright long a call.
I only employ this aggressive strategy when I feel there is a very, very attractive entry point that presents the potential for a strong counter move. At the same time, the put spread offers us a tight stop-loss level. The position is rarely held to expiration, so in case of an adverse price move, the short spread will not go to full value, so the maximum loss will rarely be incurred.
As an example, let’s say IBM shares were at $195 at the end of April. The put spread would be in-the-money, and with three weeks until the May expiration, it would be worth approximately $2.50. Given it was sold for a $1.30 credit, the loss, if closed, would be $1.30, not the full $5, which is the width of the spread ($200 - $195).
So by turning that put into a spread, we can define downside risk and avoid a serious reversal of fortune.
By Steve Smith, Contributor, Minyanville