The Risk Reversal spread is a favorite of mine when options premiums are elevated and when I’d be comfortable owning stock at a discount if the stock was “put” to me.
The main thrust of this trade is to get elevated options premiums to work for you to give you a “free ride” on a stock. When premiums are elevated, that suggests market participants are expecting a big move may be about to happen. If your bet is that the big move will be up, then the Risk Reversal spread gives you the opportunity to sell puts to fully finance your long call trades for participation on the upside. If the stock ends up staying in a choppy, but contained range, then no harm or foul — you’ll simply walk away with the small credit you incurred when putting the trade on. And if your thesis is completely wrong and the stock craters, then it’s possible you’ll become an owner of long stock at the price of your short puts strike.
The above P/L profile shows where your profits and losses would materialize in a hypothetical Risk Reversal trade. In this hypothetical trade with the underlying trading at approximately $43, you’d be short the 38 strike put and long an equal amount of contracts at the 48 strike calls. Ideally, you’ll choose strikes such that the call premium is slightly less than the put premium. The net result of these two trades (a credit for the short puts and a debit for the long calls) will sum up to a small net credit.
I generally like to put these trades on when I’m bullish on a stock. And I also prefer to only execute this trade in stocks that pay dividends. This gives me a little bit of comfort in knowing that in any worst case scenario where the stock collapses and my short puts get exercised against me making me an owner of long stock, I’ll at least have the potential to get paid dividends while I aggressively sell covered calls against my long stock to keep cashflow coming to me. This will increase my chances of at least getting out of this whole position at or close to breakeven.
When the stock goes my way and I’m feeling aggressive, I can also obtain some cashflow by “rolling up” my short puts a little bit closer to the action for further credits. In the above example, if the underlying moved up towards $48, I could cover (close) my short 38 puts for a profit, and then open a new short put position perhaps at the $40 strike put for an additional credit. Additionally, when I’m lucky enough for my long calls to go in-the-money, there will be opportunities to roll up the long calls to pull cash flow out while still maintaining exposure to any further upside. In this example, if the stock traded to $50 per share, I could sell to close my 48 strike calls while simultaneously purchasing to open 50 strike calls. This trade would yield a net credit.