[Options] My Favorite Strategies: Bullish Risk Reversals

Sean McLaughlin
October 20, 2021

(While on vacation until Oct 26th, I’m going to be sharing some anecdotes on my favorite trading strategies: why I use them, when, and how I manage them once they are on.)

Ok, so perhaps there's some recency bias here as the most recent bullish Risk Reversals I've put on have worked. Really though, all that has done is remind me that I should probably do more of these trades.

In a nutshell, a bullish Risk Reversal is a trade where we short naked puts and use those proceeds to pay for long calls. That's right, the market pays me to get long!

The trade is put on for a small net credit (ideally), and the short term goal is to ride an increase in the value of the calls which will allow us to sell a portion of them and use those proceeds to buy-to-close all the naked short puts. This then leaves us long the remaining portion of our calls for free! The calls could eventually reverse on us and go to zero, but we'll still keep the credit we received when we originally put the trade on (plus whatever credit we may have gained when we sold some calls to close all the puts). This is a great situation to be in!

This type of trade works best on stocks that we're bullish on and are experiencing elevated levels of implied volatility which is raising options values. We want to sell that juicy premium in the puts to finance our long calls purchase.

I generally prefer large cap stocks that don't typically exhibit any large gapping price behavior. But the ultimate risk management move in these trades is to size the position such that if we were to get assigned against our short puts (meaning, we become owners of 100 shares of stock per each short put contract we hold), the value of the new long stock wouldn't represent more than approximately 10% of my trading capital. This may seem conservative to some, or too much for others, but this is the level that feels right for me and my risk tolerance.

Here's how a typical PnL graph for a bullish Risk Reversal would look:

This is a bullish Risk Reversal trade I did in $FCX November options recently. You can see that with FCX trading around $31.25, I sold the 28 puts for an 87 cents credit, and purchased the 36 calls for a 69 cents debit. The total combined net credit for the trade was 18 cents. So if absolutely nothing were to happen and both of these options expired away worthless, I'd keep that 18 cents as profit. Not what we're playing for, but better than a loss, right?

We're still in the trade as I type this, but we've already had an opportunity to sell 1/3rd of our calls and I used the proceeds to completely pay for covering all of my naked short puts. So now I'm free-riding some long 36 calls! Yahtzee!

Keep in mind, when I put these trades on, they don't always work out. So, another way I minimize the risk of taking a large loss (besides proper position sizing), is to always have a risk management level in mind that is my "uncle" point. It doesn't need to be anything complicated, but there has to be a level of clear support on the chart that, if broken, represents a clear signal that the bullish trend I'm riding has been busted. Once that level is broken, I'm out. No questions asked.

This is one of my favorite trades because I simply love the idea of having the short puts pay for my long calls position. And I love that I really only lose in 1 out of 5 scenarios -- a large adverse move in the underlying. If the stock only goes down a little, stays completely flat, or only rises a small amount, then all the options expire worthless and I keep the initiation credit. And in the last of the 5 possible scenarios -- a large up move -- I can hit a homerun. I like my chances here.

Have you ever traded bullish Risk Reversals? I'd love to hear how you do it.

~ @chicagosean

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