How Risk Reversal Trade Works For TLT

How Risk Reversal Trade Works For TLT

Buying a call option and selling a put covers both sides of the fence.

Reviewed by: Scott Nations
Edited by: Scott Nations

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

Buying 100 shares of the iShares 20+ Year Treasury Bond ETF (TLT | A-85) would have cost $12,456.00 at the close of business last week, and given the one-year performance of TLT, it would be tough to have any confidence you’d make money on your investment.

But one institutional options trader went long TLT and got paid for doing so. And unlike simply selling a put option, this trader will make more money as TLT moves higher.

Options traders looking for long exposure to TLT can always buy a call option. A call option gives the owner of the option the right—but not the obligation—to buy TLT, and he’ll exercise his option if TLT is trading above the strike price of the call option at option expiration. That means that as TLT continues to rally in price above the exercise price, the call will continue to increase in value along with it.

But call options are expensive. One way to offset this cost would be to simultaneously sell a put option. Buying a call option and selling a put option means that in addition to choosing to buy TLT if it rallies, we will be forced to buy TLT if it falls in price.

But we wanted long exposure to TLT, and that means we run the risk of TLT dropping in price. Selling a put option to complete the exposure means we’ll collect premium that can more than offset the cost of the call option.

Getting Paid Both Ways

The result is long exposure to TLT, down as well as up, while paying for the up exposure and getting paid for the down exposure. This trade structure—long a call option and short a put option—is called a “risk reversal.”

If we select the strike prices for our risk reversal carefully, we can get paid more for bearing the down exposure than we pay to get the up exposure, and that’s exactly what our institutional option trader did.

On Friday, he began by buying 4,000 of the TLT $127 strike call options expiring on Oct. 16. He paid $0.85 per share when TLT was trading at $125.68. Since each option corresponds to 100 shares, these calls cost a total of $340,000 and give him the right to buy 400,000 shares of TLT at $127.00 per share before the close of business on Oct. 16.

Since TLT was at $125.68, TLT has to rally quite a bit before these call options will be profitable at expiration. If TLT is at or below $127.00 at expiration, these calls will expire worthless, and the entire $340,000 will be lost, and they don’t break even at expiration until TLT is at $127.85.

Offsetting Risk

To offset that risk, our trader also sold 4,000 of the October $125 puts at $1.08. By selling these put options, our trader collected a total of $432,000 and has agreed to buy 400,000 shares of TLT at $125.00 if it’s trading below that level at that October expiration.

Our trader has now pocketed a net $0.23 per share, or a total of $92,000, and will pay $127 for TLT if it’s above there at the October expiration, and will pay $125 for TLT if it’s below there at option expiration. If it’s between those two strike prices, both options will expire worthless, and our trader counts the $92,000 as his profit.

By looking at the payoff profile for this combination of long call option and short put option, you can see it is similar to simply owning TLT at $125.68, which is where it was trading when the options were executed, with some important differences.

The most obvious difference is that with TLT between $125 and $127 at expiration, the total profit for the risk reversal is the net of $0.23 collected per share; and below $125.00, the risk reversal outperforms slightly; while above $127.00, it underperforms slightly.

This unique payoff profile is generated by combining two option strategies—long a call option and short a put option—into a new strategy: the risk reversal. Combining strategies like this allows every ETF investor to create unique payoff profiles that can’t be created any other way.

At the time of writing, the author held no positions in the above-mentioned securities. Follow Scott on Twitter @ScottNations.

Scott Nations is president and CIO of NationsShares. NationsShares is a leading developer of domestic and international option-based and option-enhanced investment products. He is the creator of VolDex (ticker symbol: VOLI), an improved measure of option-implied volatility on SPY, the S&P ETF.