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9 Weeks to Better Options Trading: Risk Reversals

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Veteran options trader Steve Smith breaks down the risk reversal.

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Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.

For the first article in the series, click here.

If you are a novice options trader, we suggest you start with Steve Smith's 6-Week Options Trading Kickstarter series.

In previous articles in this series, we've looked at popular options trading strategies like calendar spreads, butterfly spreads, and condors, all of which use the simultaneous purchase and sale of puts or calls to create limited risk or partially hedged positions.

These traditional spreads allow you to reduce costs in exchange for capping gains. This week, we're getting more aggressive and drilling down into a strategy known as the risk reversal, which uses combinations of puts and calls to create a low-cost position that carries both unlimited risk and reward.

A risk reversal consists of being long (buying) an out-of-the-money call and being short (selling) an out-of-the money put, both with the same expiration date.

What makes the risk reversal different from most leveraged speculation or hedging strategies is that it aims to achieve a position with a very strong directional bias, but with a minimal capital outlay or possibly even a credit.

When constructing a risk-reversal position, the sale (purchase) of the put should offset the cost (credit) of the call.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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