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How Risk Reversals Offer a Better Alternative to Trading Stock

Even though the $VIX is very low relative to recent action, the implied volatility skew is very high.

Out of the money puts are expensive, and out of the money calls are cheap.

That tells me that plenty of investors are willing to pay up for protection... a ton of skepticism.

Take the Other Side

Let's say you wanted to take a long position.

You could buy stock....

or you could take advantage of this options skew by putting on a bullish risk reversal.

What is a Risk Reversal?

A bullish r/r is a combination of a put sale and a call buy.

You receive a credit for the put sale, and you have to pay a debit for the call.

Many times, the put will pay for the call.

Here's an example in $CSCO:

Advantages of Risk Reversals

  • you end up with a stock-like position with a fraction of the capital required
  • you take advantage of the higher implied volatility on the puts
  • if the stock moves against you but stays above the short strike, your losses are minimal into expiration

Disadvantages of Risk Reversals

  • time-decay in the position will eventually come in, so you do need to see a decent move
  • there still is unlimited downside risk so you need to adhere to stop losses just as you would with a long stock position

As long as this elevated skew persists, there will be a natural advantage to this trade over long stock positions.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/