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Option Strategy: Risk-Reversal

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

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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

and

-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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