[Options] Risk Management Best Practice with Risk Reversals

Sean McLaughlin
March 13, 2019

One options strategy that we occasionally employ at All Star Options is a bullish Risk Reversal. This is a trade we like to put on when the cost of naked calls is too high for our comfort (due to high volatility and/or higher priced strikes), and we're comfortable taking ownership of long stock in a "worst case" scenario.

Simply, it is a trade where we typically purchase an out-of-the-money call, and finance this purchase (all or in part) with the sale of an equal amount of naked puts in the the same expiration cycle.

This is an advanced-level trade that requires more buying power than most trades we put on (due to the naked puts component) and a higher level of comfort with risk. A typical risk reward graph would look like this:

We're going to use the above trade in $VAR as an important example in risk management best practices.

We put on this trade back on January 30th and paid a net debit of 90 cents when $VAR was trading around $130/share. Since that time, $VAR has moved higher in our direction, now trading around $136/share.

If we were greedy, we could attempt to keep riding this position higher as is. But the prudent risk manager in me is always looking to minimize or eliminate "unlimited" risk.

One way we do this with Risk Reversals is look for opportunities to sell half of our long calls for enough credit to pay for us to purchase all of the naked short puts back.

In this $VAR example, today we were able to sell half of our call position and after buying to close all of our naked puts, we were left with a 90 cents credit. Essentially, we earned back the original 90 cents we paid to originally put the trade on, and now we’re holding a half position of long calls for free! In other words, we are now long calls for ZERO RISK!

This, my friends, is prudent risk management and how I love to manage bullish Risk Reversals.

If you like content like this, you should join All Star Options!

~ @chicagosean

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