What is a Risk Reversal Options Strategy? Entering to my First Risk Reversal Strategy

by Evan

Last week I went with The Wife and my 2 kids to Disney.  It was the first time I had been there since we went almost 5 years ago. I couldn’t believe just how many people were there! Every park I went to (Magic Kingdom, Hollywood Studios, Animal Kingdom and Epcot) was extremely busy.  Granted, I don’t have anything to compare it to but these places were nuts.  Some rides had a line from opening till close of 2+ hours.  This shocked me even more given that I pulled my kids from school (and local schools were not off either) and the pure price tag of everything.

These are the advertised, pay in advance pricing I got when writing this post (the pay when you get there price was significantly higher):

Disney Ticket Prices

I have been long Disney for years.  The content and IP they have is absolutely insane, they own all of or pieces of:

  • Star Wars (LucasFilms)
  • Marvel Studios & Entertainment
  • Disney Music
  • Muppets
  • ABC (ABC affiliates and Shows)
  • Pixar
  • Hulu
  • A&E
  • History Channel
  • Lifetime Vice
  • ESPN

Even after we move past the content and IP they have Disney World! Over 27,000 Acres in a city/state which they basically own.

As I was sitting on a bus (that they own) from a park (which they own) after buying food and crap (which they marked up) to go to a hotel (that they own), I thought in 10, 15 or 20 years are they still going to be printing money? My feelings on the topic is yes.  Maybe they don’t have the growth they have had in the past, or maybe they have more, I am not entirely sure! Nonetheless I am feel pretty strongly that Disney is going to be here for decades to come (hopefully, this post ages well).

So as I sat on this bus in a fog of exhaustion and happiness I thought to myself that there has to be a way to increase my long position without tying up a ridiculous amount of capital.  So I started thinking about LEAPs (couldn’t google anything as my phone was of course dead).  A LEAP is basically a long term (over 1 year) option to buy a stock at a certain price.  However, that contract costs money, so I started to quickly think how I could offset the cost of buying them outright?  I would sell naked puts!

I know I couldn’t be the first person to come up with this strategy but I was having trouble finding the name of it when I finally got some juice back into my phone. So I turned to the Options Page on Reddit, and like with most things on Reddit I got 3 wrong answers and 1 perfect one.

What is a Risk Reversal Options Strategy?

Once I got the name of the strategy it was easy to find that it matched up.  From Wikipedia,

A risk-reversal is an option position that consists of being short (selling) an out of the money put and being long (i.e. buying) an out of the money call, both with the same maturity.

A risk reversal is a position which simulates profit and loss behavior of owning an underlying security; therefore it is sometimes called a synthetic long. This is an investment strategy that amounts to both buying and selling out-of-money options simultaneously. In this strategy, the investor will first make a market hunch; if that hunch is bullish he will want to go long. However, instead of going long on the stock, he will buy an out of the money call option, and simultaneously sell an out of the money put option. Presumably he will use the money from the sale of the put option to purchase the call option. Then as the stock goes up in price, the call option will be worth more, and the put option will be worth less.

This differs from the Synthetic Long strategy,

Isn’t a risk reversal the same as a synthetic long stock position?

In the world of options, a “synthetic long stock” position is created by selling an at-the-money put option and simultaneously purchasing a call option with the same strike price, underlying stock and expiration date. The resulting position shares a similar risk profile as a long stock position: unlimited theoretical gains and losses. The risk reversal strategy is slightly different, in that the strikes selected for the put and call options are out of the money. But neither strategy offers the benefits associated with stock ownership, such as dividends or voting rights.

My First Risk Reversal Trade

I immediately went to the longest LEAP available, the January 15, 2021 contracts where I found:

Disney LEAP Option

Let’s break down each leg of the trade:

  • I sold a naked put with a strike price of $80. This means at any time between now and January 15, 2021 someone out there could “put to me” 100 shares of Disney at $80.00 per share.  So as long as Disney stays above $80 there is no real chance of the stock being put to me.  Why would anyone stick me with $8,000 worth of Disney if those shares are worth $8,000 + X.  For the right to put it to me I was provided with compensation of $216.98.
  • I bought a Call with a strike price of $150 for $294.02.  This allows me to “call away” 100 shares of Disney for  $150/share at any time between now and January 15, 2021.  However, unless the stock is trading above $150, there is little reason for me to actually call away the shares.

When you net out the two legs I paid a total $77.04, however, that is not the most I can lose.  Theoretically, Disney could go bankrupt and if that occurs I can still be put $8,000 of a defunct Disney.  I don’t think anyone out there is making the case that Disney is going bankrupt anytime soon.  My possible profit starts if/when Disney hits $150.00 per share and keeps on going from there (minus the cost of the trade). For $77.04 I am controlling 100 shares of Disney currently valued at $11,000.

As of the date of this post/trade Disney is at about $110.00/share.  So to profit I am going to need some real growth over the next 18 months.

Would I Use Risk Reversal Again?

In the right situation I think it allows me to use a small amount of capital to make a large bet.  In this particular case it only cost me $75.  If it hits, fantastic! If it doesn’t, I don’t see Disney going down 30 to 40% in 18 months.

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