The following is a guest post by our good friend Gavin Mcmaster from OptionsTradingIq.
Recently I posted a chart on my blog, which is also shown below.
Image Credit: Chris Ciovacco
It’s hard to argue that this chart looks anything but bullish.
Stocks may be extended short-term and due for a pullback, but if a trader wanted to take a bullish position a risk reversal provides can be a good option.
BE PREPARED TO TAKE OWNERSHIP
The key with a bullish risk reversal is that you need to be prepared to buy the underling at the strike of the short put. If the underlying is below the strike price at expiry, the stock will be put to you.
The beauty of the risk reversal is that it takes advantage of the inherent skew in options. Generally, implied volatility is higher for puts than calls.
Assuming a trader is bullish and thinks the SPY will head higher by March, he could construct a trade that looks something like this:
Here the trader is choosing the 25 delta calls and puts, giving an overall exposure level of 49 delta. In the short-term, the position will perform similar to owning 49 shares of SPY. Of course, as the underlying changes, so two will the Greeks.
The beauty of the trade is that you can own upside exposure and get paid if the stock goes nowhere. If the stock falls, you end up taking ownership for a price less than when the risk reversal was initiated.
WHEN TO TRADE RISK REVERSALS
A great time to use risk reversals is when a stock has had a sharp selloff. During these times implied volatility for the puts can go through the roof as traders try to protect against further downside. High risk tolerant traders can even trade leveraged risk reversals in this case. Due to the high premium received for selling puts during market panics, the trader can buy 2, 3 or even 4 calls for a net cost of $0.
Just think how this strategy would have performed during recent selloffs.
These trades also work well if the trader is expecting a minor pullback but realizes it might not happen. If markets continue moving higher, he gets partial benefit and if stocks fall he takes ownership at a lower price.