The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website

CHAPTER 10

Risk Reversal

If you were bullish on a stock, you might buy an out-of-the-money call option. If the stock rallied above the strike price of the call by more than the price of the option, then you would make money. But the rally required, to a level that is above the strike price by the cost of the option, can be pretty big, particularly if we’ve bought a call on a stock with a high implied volatility or if we’ve bought a call that’s substantially out-of-the-money. And in buying a call option we can be right, the stock can rally, and we can still lose money if it doesn’t rally enough.

Or you might sell an out-of-the-money put. This is a bullish to sideways position. As long as the stock didn’t drop below the strike price of the put by more than the premium received this trade would be profitable. In selling a put, you wouldn’t have to pay any premium; in fact, you’d be collecting premium, and that premium would be yours to keep, no matter what the underlying stock did. If the stock is below the strike price at expiration, then you’re going to end up buying the stock at that strike price, but selling a put works best if the stock has moved up or sideways at expiration and if the stock appreciates enough then the amount of put premium collected will be tiny in relation to the profit from buying a call option even though the call option requires us to pay for the option.

If you were to combine these two positions, long a call option and short a put option, you would ...