Monday, January 11, 2010

Options Action- JPM Risk Reversal

The subjects covered in my last post, namely sector rotation and imploding volatility, received some face time in Friday night's Options Action. What insight did the gurus have to add?

Well, none really.

As to whether or not the rotation out of tech and into financials is here to stay, the best two points made were:
1. it's tough to read too much into one week's worth of trading (agreed) 2. if the market's uptrend continues, no doubt technology will be bought up and one point or another so the weakness may be short lived (agreed).

What about volatility? All fingers pointed to the usual suspects most of us are no doubt already aware of: low volume over the holidays, less trading days in the Jan cycle, and an absence of any huge market moving events.

As earnings season is coming round the corner, a few earnings related option plays were discussed. The one I'd like to muse over for today was a risk-reversal on JP Morgan Chase (JPM) currently trading around $44.60. In anticipation of a neutral to mildly bullish earnings reaction, the suggestion was to simultaneously sell a Feb 42 put for $.85 and buy a Feb 48 call for $.50 resulting in a net credit of $.35. For those that are in unfamiliar territory when it comes to risk reversals, it can be easily understood when broken down into its individual parts. It simply involves selling one OTM put and then buying one or more OTM calls with the proceeds.

By selling the JPM Feb 42 put, you obligate yourself to buy 100 shares of JPM at $42. The ideal scenario would be for JPM to remain above 42, allowing the put to expire worthless and you to keep the $85 credit received. By also purchasing the Feb 48 call for $50 debit, you gain the right to purchase JPM if it rises above $48 by Feb expiration. The alluring aspect of adding the 48 call to the short 42 put is that you now have unlimited upside profit potential if JPM rallies strong off of earnings. The drawback to the long 48 call is that you have to give up $50 of the $85 credit received from the short 42 put. If JPM fails to rise sufficiently, then you've essentially thrown away that $50.

Normally I'd offer up a risk graph illustrating the pay-off diagram for the trade, but my software is refusing to give me option quotes. So the following chart will have to suffice for now. I'll post the other chart when my platform decides to get its act together.
[Source: EduTrader]

I tend to prefer simply selling puts to entering risk-reversals, especially since buying short term OTM options is usually a low probability bet. Though if I wanted to swing for the fence and bet on a large bullish move, risk-reversals aren't a bad way to do it.

For related posts, check out:


steveplace said...

For your viewing pleasure:

Tyler Craig said...

Many Thanks Steve-