Reversal

[Igor 10]

Traders who implement a reversal strategy are taking advantage of under priced assets by instantly liquidating (arbitraging) them to fair market value. The technique involves selling and purchasing a put and a call option, at-the-money, while short selling the underlying asset. Traders can earn a small, risk-free profit when using a reversal strategy, as long as the two under priced option's values are lower than their associated underlying asset.

 

Moneyness Review for Puts and Calls

 

Call Options:

 

In-The-Money (ITM) = Strike price (less than) Market Price

Out-of-The Money (OTM) = Strike price (more than) Market Price

 

Put Options:

 

In-The-Money (ITM) = Strike Price (more than) Market Price

Out-of-The Money (OTM) = Strike Price (less than) Market Price

 

Both Put and Call Options

 

At-The-Money (ATM) Strike Price (equals) Market Price

 

How to Carry Out A Reversal Strategy

 

 

Disney stock is worth $100 (market price) in June.

1) Trader short sells 100 shares of Disney stock.

2) Trader sells the put option: DISJul100($4)

- 100 shares of Disney stock

- Strike Price $100, at-the-money (ATM), expiring in 30 days

- Premium Cost of $4

3) Trader buys the call option: DISJul100($3)

- 100 shares of Disney stock

- Strike Price $100, at-the-money (ATM), expiring in 30 days

- Premium Cost of $3

4) Trader receives a $10100 credit when entering the market. [$10000 (received from short sale) + $400 (received from put) - $300 (paid for call)]

Total cost to enter the market: -$10100

 

Result one: Disney stock rises (rallies) to $110 in July

a) The put option sold expires worthless. (OTM)

b) The call option purchased expires ITM.

c) The trader exercises his or her right to buy 100 shares at $100, paying 10000 to the seller.

d) The trader uses the 100 shares to cover the short sale.

e) Trader gains a total of $100 after keeping the remainder of the credit earned when entering the market. [$10100 (credit) - $10000 (paid for shares]

 

Result two: Disney stock falls to $90 in July.

a) The call option purchased expires worthless. (OTM)

b) The put option sold expires ITM.

c) The investor who bought the trader's put option exercises his or her right to sell 100 shares at $100. The trader pays $10000 to the buyer, and receives 100 Disney shares.

d) The trader uses the 100 shares to cover the short sale.

e) The trader makes a total profit of $100 after keeping the remainder of the credit earned when entering the market. [$10100 (credit) - $10000 (paid to cover put)]

 

Calculating The Risk Free Profit In A Reversal Strategy

 

Investors earn instant profits when correctly entering a reversal trade. Market conditions will not matter at the time of expiration, as the synthetic long stock position covers losses and cancels gains on the short sale. In order to achieve instant profits, the price of the underlying asset must exceed the difference in premiums collected less the options' strike prices. [$100 = $100 (asset price) + $100 (premium credit) - $100 (options' strike prices)]

 

Advantages and Disadvantages of Implementing a Reversal Strategy:

 

Pluses: The upside to this type of strategy is that the investor will always make a small profit in any market situation, risk-free. The trader is just arbitraging the under priced options to fair market value.

 

Minuses: There is no downside in carrying out a reversal strategy, since it risk-free. However, traders must be able to recognize under priced options of which values are lower than their associated underlying asset.