From the December 2013 issue of Futures Magazine • Subscribe!

Using a risk reversal spread for protection in volatile markets

Solution: The risk reversal

Strategically combining the long put and short call verticals into one position can be a forgiving and powerful position that affords the trader patience and more flexibility than utilizing one spread alone. 

Both spreads usually will be constructed with out-of-the-money options. Having an out-of-the-money call spread provides room for further stock advances without the short (bearish) spread going in-the-money. Having an out-of-the-money put spread allows for a less expensive entry cost, thus providing more potential profit. 

For example, let’s assume that the Dow Jones Industrial Average is at all-time highs and trading at 15,900. The proximity to 16,000 may be enough to frighten people without the economic and political events on the horizon. To have a position on with some time to breathe, we can go out into the 45 days until expiration expiry in the SPX when the SPX cash is at 1795. 

The net credit received on the short 1855-1850 call vertical spread (–$5.20+$6.20=$1.00) completely offsets the debit paid for the 1750-1745 Put spread (–$17.30+$16.30=–$1.00). Should the market glide slightly higher, remain constant or fall only slightly, the position simply expired worthless with no loss other than commissions.

Option traders who appreciate both long and short vertical spreads will find it difficult not to appreciate the alchemy created when combining the two strategies. This particular strategy affords time and forgiveness to the trader who is not able to pick the exact moment when the market reverses.

J.L. Lord is an analyst and author at RandomWalkTrading.com, a trading education firm employing retired floor traders (only) as their instructors. He can be reached at RandomWalkTrading.com.

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