My scanner picked up on a trade called a risk reversal this morning.
The most basic version of a bullish risk reversal is selling an out-of-the-money put and buying an out-of-the-money call. However, you can execute this type of trade with in-the money, or at-the-money options as well.
The risk reversal that my scanner picked up on this morning was in Goodyear Tire (GT). The company will report earnings tomorrow before the open and the stock is currently trading 27.70. Here are the details:
A buy of 3,500 August 28.5 Calls for $0.90
A sale of 3,500 August 30 Calls for $0.35
A sale of 3,500 August 26 Puts for $0.43
This is an extremely bullish trade as the trader bought a bull call spread and sold a put.
Breaking down the trade, we see that he paid $0.55 for the call spread and collected $0.43 from the sale of the put. So his net capital outlay on the position is $0.12.
On the upside, the trader breaks even at 28.62 (28.5 + $0.12) and can make $1.38 if the stock trades at 30 or above.
On the downside, the trader will lose $0.12 until the stock trades at 26 or below. At that point, the trader would be long 350,000 shares of GT as the buyer of the put would exercise his right to sell the stock to the spreads buyer.
Bullish risk reversals are just about the most bullish position a trader can put on. If it works, it can be a home run as the capital outlay is minimal because of the sale of the put. However, if the trade goes bad, it can be extremely bad as the trader is exposed to significant downside risk.
This type of trade makes sense if you are extremely bullish on a stock, and willing to buy the stock if it falls in price.
I am not recommending this trade in front of Goodyear’s earnings. However, I will add this strategy to our trading playbook and look for similar opportunities in the future.
Risk Reversal Follow up
Goodyear Tire (GT) reported earnings this morning and the stock is trading lower by 1.30. We did not initiate a position in the stock as I didn’t see any great “edge.”
However I mentioned a trade yesterday that I thought would be a good way to introduce a new strategy for us called a risk reversal.
As I said in yesterday’s email, a risk reversal is an extremely bullish trade. If the stock goes down, the trader will likely lose on both sides of the trade as he bought a call spread and sold a put.
On the open this morning, the trader immediately took off his position, illustrating good risk management as his short puts are now in play.
Here was the trade yesterday:
A buy of 3,500 August 28.5 Calls for $0.90 A sale of 3,500 August 30 Calls for $0.35 A sale of 3,500 August 26 Puts for $0.43
Here are the prices at which he took the position off this morning:
A sale of August 28.5 Calls for $0.35
A buy of August 30 Calls for $0.17
A buy of August 26 Puts for $0.30
The big takeaway from this trade is the discipline the trader showed in taking off the trade when it went bad, and the fact that he was able to cover his short puts for a gain even though the stock was down. However, he clearly lost on his bull call spread and the trade was a loser.
This morning, my scanner picked up on a similar trade in Dollar General (DG).
Here was the trade:
A buy of 1,500 DG November 62.5 Calls for $1.50
A sale of 1,500 DG November 52.5 Puts for $1.625
In this instance, the trader received a $0.125 credit to put on this spread.
I’ve been watching DG quite closely for the past several weeks as a trader bought 65,000 November 57.5 Calls for approximately $2.75. However, this was after he took a big loss on a similar position on November 62.5 Calls.
I may look to get into a trade in DG after the Fed announcement this afternoon.