Options Article

Why implement a risk reversal strategy with options?

Last Updated: September 30, 2020

Article Summary
Key Takeaways

Why implement a risk reversal strategy with options?

Simply in order to have more room for noisy movements in the underlying?

A Risk Reversal is a great setup to get synthetically long stock. There are a few advantages as others have touched on, but would like to add a few advantages and considerations:

  1. Take advantage of skew, as others mention. This is because (generally) there is more perceived downside risk than upside and options (generally) are priced higher (higher IV) for puts than for calls. This is the same reason I recommend people interested in covered call strategies to also consider Short Put Writing, as (again, generally) the payoff is higher on the short put for a position that is synthetically the same.
  2. Fine-tune risk reward. If a short put is sold ATM and a long call is purchased ATM this is a synthetic long stock position. We did a full article on synthetic positions you can read here. The trader can also widen out strikes to match their view on support/resistance levels. In fact, selling a further upside call converts the long call into a vertical and can improve your downside protection already offered from the trades skew.
  3. Longer Time-Frames are often appropriate. You may want to consider a longer expiration on the long call than you might usually trade. You can either keep the short put the same duration or shorter duration and sell a second put / roll the short put a few days short of expiration.
  4. Shop for Skew. You might want to keep a watch list of tickers that you’d consider getting (synthetically) long and scan frequently for increased skew. Usually you will see the highest skews during times of increased underlying IV Percentile / Rank.
  5. Additional Opportunities for the Long Side. Selling the short put is clear, but as above, you may want to consider additional combinations of call contracts to get long. One of my favorites as actually to buy 1 call and sell 2 further out of the money calls (call ratio spread). Generally I can either push the put further out of the money or really extend the upside 2x calls very far out of the money. Please note, that this type of trading is really only for advanced traders as you will be ‘naked’ a call, which has unlimited risk. Please don’t trade this yet, but I just wanted to give you a preview of the power of such positions.
RELATED READ  What’s the Difference Between Selling a Put and Buying a Call?

Hope that helps. Reach out anytime if you have questions.

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