How Bull Risk Reversals Attempt a Rare Win-Win Scenario in Investing
In layman’s terms, option calls and puts are bets on whether a stock is going to rise or fall. A call is a bet that the stock will rise, and a put is a bet that the stock will fall.
Whenever my proprietary options screener alerts me to a trader buying 10,000 calls and risking many millions of dollars, my alarm bells go off. Who is buying these calls, and why is he taking such a big position? Does he have insider information?
Warren Buffett, Carl Icahn and Bill Ackman are just a few of the many hedge funds and institutions known for using options to build positions, and when I see a stock that is having consistent and large options trades, I take notice. You’ll see the bulls actively buying calls nearly every day looking for a stock to move higher.
And while straight call purchases are bullish, the trade structure that I find to be the biggest tell of the conviction these hedge funds have in a stock is an option trade called a “bull risk reversal.”
Bull risk reversals are a favorite tool for sophisticated hedge funds and are just about the most bullish trade you can execute using options because both components of the trade benefit if the stock heads higher: both the call buy is bullish and the put sale is bullish.
And what makes these trades so profitable (if they work) is that the premium collected via the put sale often pays for the premium paid for the call purchase.
Bull Risk Reversals Explained
Here’s how bull risk reversals work.
A bull risk reversal is typically used when a rise in the price of the underlying asset is expected. The strategy usually involves the sale of an out-of-the-money put and the purchase of an out-of-the-money call. The trade has unlimited profit potential to the upside and extreme loss potential to the downside.
For example, a January 20/25 bull risk reversal for a $1 credit would be:
- Sale of January 20 Puts, and
- Buy of January 25 Calls.
If the stock stays between 20 and 25, the trader collects the $1 credit.
If the stock goes to 20 or below, the trader will be forced to buy the stock at 20.
If the stock goes to 25 or above, the trader will exercise his right to buy the stock or simply sell his call for a profit.
This is one of the rare win-win scenarios that investors are always reaching for, but rarely obtain. At its worst, the strategy minimizes loss.