CASE STUDY: Yahoo Oct 14 – 16 Bullish Risk-Reversal — *expired*

| September 5, 2012 | 0 Comments More

Yahoo (YHOO) adds 17 cents to $15.06 and an Oct 14 – 16 bullish risk-reversal trades on the Internet giant at 4 cents, 48000X on ARCA. Puts were sold to buy calls. Doesn’t look tied and, while open interest is sufficient to cover, this looks like a new position (stock exactly midway between two strikes and record volume in both contracts.) If so, the bullish combo seems to be a decisive bet that shares will hold above $14 and possibly rally beyond $16 through the Oct expiration (44 days). The stock is still trying to recover from the 3-day 8 percent loss suffered after the company released a 10-Q that discussed plans for new CEO Mayer on 8/10. The stock was at multi-month lows Friday before rebounding 2.7 percent so far this week. Let’s open this combo as a Case Study of a Bullish Risk Reversal for a Net Credit.

A bullish risk-reversal is a straightforward combination play in which the investor is selling downside puts to buy upside calls. The risk-reward is similar to a synthetic stock position (buying calls and selling puts with the same strike and same expiration month), but in a typical risky, the investor is selling downside puts to buy upside calls. Both contracts are out-of-the-money and the trade can be initiated for a debit, credit, or at even money. The strategy can take advantage of implied volatility skew and the fact that out-of-the-money puts often have higher implied volatility compared to out-of-the-money calls. Like when selling naked puts, the investor stands ready to be assigned on the puts and buy the underlying at the strike price of the put. That is, if shares fall below the strike of the put, assignment becomes a factor at or near the expiration.

A downside move in the underlying is the biggest risk to the bullish risk-reversal. The breakeven (at expiration) when the combo is initiated for a debit, is equal to the call strike plus the debit. The debit is at risk if shares hold between the two trikes. When sold for a credit, the breakeven of the risk-reversal is the put strike minus the credit and the credit is kept if shares hold between the two strikes and both contracts expire worthless. The best profits from a bullish risk-reversal, whether for a credit or debit, occur if shares rally and the calls increase in value – with theoretically no limit for potential gains.

In this case, shares are trading for15.06 and YHOO Oct 14 – 16 bullish risk-reversal traded for 0.04. The max risk to the trade is the put strike minus the credit, if shares fall to zero, or 13.96. There is no risk to the upside because the credit is kept if the puts expire worthless. The breakeven is equal to the put strike minus the credit, or 13.96 and -7.3% from current levels. The max profits happen if shares rally beyond the call strike. If shares hold between the two strikes, the options expire worthless and the credit is kept. Of course, the position can also be closed out for a profit or loss at any time prior to the expiration. The OptionsXpress payoff chart shows the risk-rewards and probabilities of success graphically.

Case Study: YHOO Oct 14 – 16 bullish risk-reversal
Bias = Bullish
Risk = Put Strike – Credit = 13.86
Reward = Theoretically Unlimited to the Upside
Breakeven(credit)= put strike – credit =13.96

Download PDF —> YHOOOct1416bullrr

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Category: All Stocks, Large Cap Stocks, Software & Computer Services, Trading Education

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About the Author (Author Profile)

Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.