In Group Coaching class every morning, we often look at MTM’s Zero Day Hero scanner to find some interesting 0-DTE trade ideas. Zero Day Hero will show you large trades that have been initiated and expire on the same day (0-DTE). It is perfect for option traders who love to day trade and have a feel about what big money is doing on the day. One trade idea that keeps coming up more often than I have seen in the past is the risk reversal trade.
What Is a Risk Reversal Trade?
A risk reversal trade is generally a credit position where the most likely scenario at expiration is for the options to expire and for the trader to keep the credit. (They can also be a debit position, but for this post we will focus on the credit position.) It is selling a put option, usually out-of-the-money (OTM), and then buying a call, generally OTM. The short put produces a bigger credit than the debit for the long call, producing an overall credit. This is generally done when there is a bullish bias on the day. With a bearish bias on the day, the opposite is done. A trader can sell an OTM call and buy an OTM put for an overall credit.
A Recent Example in SPX
Here is a recent example of a risk reversal trade idea that popped up on Zero Day Hero.
The trader sold 1,160 of the Jul-09 6165 SPX puts for a credit of 0.27 and bought 1,160 of the Jul-09 6335 SPX calls for a debit of 0.14. The overall trade produced a credit of 0.13, or $13 in real money. Both the call and put options were far OTM, and the likelihood of the options expiring worthless was much greater than of either one having intrinsic value. On this day at the close, both expired worthless and the trader realized a profit of $15,080 (13 X 1,160).
Best Case Scenario
What an option trader is really looking for is a big move higher or lower depending on if he or she is bullish or bearish sooner than later. With expiration that same day, time is of the essence, and with negative theta dwindling the long premium, a big move sooner than later would help as the delta would grow exponentially. In theory, the bullish risk reversal trade (short put and long call) has an unlimited profit, and the bearish risk reversal trade (short call and long put) has a big profit potential down to zero from the current price.
Final Thoughts
As we’ve discussed, risk reversal trades can take advantage of a relatively big move higher or lower. The bottom line is that when doing a risk reversal trade, you are selling a naked option that comes with substantial risk and margin. But if you set up a stop loss at a level you are comfortable with risking, it can potentially be a trade to add to your arsenal. Of course, anything can happen, such as a big adverse move against the position, so there is still a potential for a greater loss than what was accounted for. Cheers to options!
John Kmiecik
Senior Options Instructor
Market Taker Mentoring
