From the March 01, 2011 issue of Futures Magazine • Subscribe!

Using option risk reversal spreads

There are 16 trading days remaining until expiration and the implied volatility of the options is roughly 13.6%. We can, therefore, expect the stock to have a one sigma range of about $4.10 (or about 2.05 in either direction of the current price of $119.90). Consequently, the position’s expected range and PNL is relatively safe to the upside and has a realistic chance of making money to the downside. A normal distribution curve (Gaussian Curve) of the DJX index shows the position is fairly safe because its upside risk area is at or outside the statistical one-sigma-range for the underlying’s expected move. The downside is similar in appearance (see below).

image

We need the market to close below $116 on expiration to maximize the full potential of this spread. However, if the market has reached its top and the mean shifts lower (as expected in our opinion), then it’s alright for our long put spread to have a statistically "fair" chance of coming into its own.

This position is not for everyone, and it does carry some risk if you are wrong. Yet, many traders consider it vastly superior to shorting stock, purchasing a long put, or selling a short call by itself. As long as the stock closes between the strikes (117 put, 122 call), we still will keep our $30 initial credit. This obviously would not happen with just a long put spread position. That being said, we still prefer a long broken wing butterfly spread.

Edward LaPorte works with Random Walk, LLC., an education company that designs creative solutions to any market opinion. Their website is: RandomWalkTrading.com.

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