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Option Strategy: Risk-Reversal


This strategy has low cost and limited risk with big profit potential.

Reducing the Risk Portion

In order to limit the risk, I'm transforming the "naked" portion of the position into a standard vertical spread. Let's look back at our SPY position. Instead of selling that $143 put naked, now also buy the $141 put for $1.60 per contract. We have now created a bullish put spread for a $.60 net credit. This limits the risk to the downside. So the overall position looks like this:

-Buy one Nov. $141 put at $1.60

-Sell one Nov. $143 put at $2.20


-Buy one Nov. $146 call at $2.25

This is now $1.65 net debit for the position (pay $2.25 for call minus the $.60 collected from put spread). While this is significantly higher than $.05 debit of the pure risk-reversal, the margin requirement will have dropped from around $2,700 to just $450 since that is your maximum loss if shares of SPY are below $141 at the November expiration. This means that on a percentage basis the returns will be substantially higher.

Now the position starts with a delta of 0.52 or equivalent to being long 52 shares. But remember: Even though we have substantially reduced the risk to the downside, the upside potential is still wide open. This seems like a good trade-off.

Twitter: @steve13smith

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No positions in stocks mentioned.

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