The Call Spread Risk Reversal – Illustrated with Leap Wireless
- Posted by Greg Harmon
- on November 4th, 2011
There are many different strategies that I use with options and over the next few weeks I will go through some of them to help explain the strategy and how it can be used to access market with controlled risk. The first one in this series will be the Call Spread Risk Reversal. Sounds complicated but like most jargon once you understand what it means the name is just a good short cut to use in discussing the strategy.
Call Spread Risk Reversal
This strategy consists of buying one Call Option and selling a higher Strike Call Option, to create the Call Spread, and then selling a Put Option. Both Calls are from the same Expiry and the Put is usually from that Expiry as well. This is a strategy that requires the use or margin since you are naked short a Put. But because the downside is limited to the Strike Price of the Put, it can also be done in a non-margin account that is set up to trade Cash Covered Puts, like a IRA or 401k.
The reasoning to trade this Options Combination comes from a desire to participate in upside movement in a stock without owning and being willing to own the stock if it pulls back to the Put Strike level. Confusing? Let’s look at an example from a recent trade on Leap Wireless, $LEAP.
The chart above shows $LEAP at midday on October 31 just before it reported earnings that night. Pay specific attention to the 3 green lines on the chart. The one at 6 represents the bottoming process that occurred through October, the one at 7 the resistance where it was currently sitting and the one at 8 the next level of resistance. This chart is set up bullishly from many perspectives (contact me if you want to know) so I wanted to participate on a move higher from the earnings catalyst. But I also thought that if it fell back to 6 it would be a good place to buy the stock for a run back higher. The trade we did was a November 7/8 Call Spread Risk Reversal with a Short November 6 Put. This trade is entered by buying a November 7 Strike Call and selling a November 8 Strike Call, giving a $1 upside maximum profit, and then selling a November 6 Strike Put, exposing me to owning the stock at 6.
Why do this instead of just buying a Call Spread? Well the Call Spread itself cost about 35 cents. On its own this creates a reward to risk ratio of 2.85:1. By selling the 6 Strike Put at 35 cents, a level where I a comfortable owning the stock from a technical perspective, the cost of the combination is reduced to near zero and the reward to risk ratio is increased to near infinite on the Call Spread. Often these trades can be entered for credit. Since there is margin used there is a cost to carry that but for very short term trades the return far outweighs that cost. This trade worked out very well, close the Call Spread piece of it the next day for 45 cents and buying back the Puts 3 days later for 5 cents, for a net of 40 cents profit off of no outlay. Pretty great but my bad as at the close today it could have been liquidated for 73 cents. But what if it did not run higher? Then the Call Spread could be liquidated for any price or even held to expire worthless without worry. And if the stock fell to 6 we would have bought the stock at 6 as previously planned. A winner no matter what the price does. Or maybe more technically no chance to lose.
Not all trades work out like this one, some are much better and other not so good. But I hope this helps to give you another perspective that you can participate in the market with very controlled risk using options.
For more details on how I traded this name and for more ideas and deeper analysis, use the Get Premium button above. As always you can see details of individual charts and more on my StockTwits feed and on chartly.
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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.blog comments powered by Disqus
Gregory W. Harmon CMT, CFA, has traded in the Securities markets since 1986. He has held senior positions including Head of Global Trading, Head of Product Development, Head of Strategy and Director of Equity. (More)
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