5. What strategy can make option buyers not afraid of time decay risk?

Hello

Welcome to Tiger Academy - 「Options Advanced Strategy」episode 5.

We know that options buyers have high leverage and limited losses, especially when engaging in end-of-the-world options. It allows for limited losses to potentially yield returns several dozen or even hundreds of times the investment. However, whether you are an options novice or an experienced investor, you are aware of the saying in options trading: "Time is the friend of the seller, the enemy of the buyer." We discussed this in a previous article： Day4. Why are options losing money when the stock price remains unchanged? Therefore, despite the potential for substantial gains, being an options buyer comes with the risk of time decay, leading to a relatively low win rate.

This aspect causes much pain for many newcomers to the options market. How can one enjoy the leverage benefits of being a buyer while also hedging against the risk of time decay? The risk reversal strategy introduced by Tiger Academy today can achieve this!

1. What is a Risk Reversal Strategy?

The so-called risk reversal strategy is essentially buying a call option while simultaneously selling a put option, or buying a put option while simultaneously selling a call option. The former is a bullish direction, and the latter is a bearish direction.

This strategy, unlike the combination option strategies we introduced before, is a multi-leg strategy, but it is an unequivocal directional strategy. It essentially bets on the stock price moving in a single direction—either upward or downward.

For example, if we believe that Tesla's stock price will rise before December 29th, we can buy a call option with a strike price of $252.5 while simultaneously selling a put option with the same strike price. The expiration date is set for December 29th. The net premium paid is $0.34 ($5.15 - $4.81).

If Tesla's stock price indeed rises, both the purchased call option and the sold put option in the risk reversal strategy will be profitable, and vice versa for a price decrease.

Since this strategy involves speculating on direction, what are the advantages compared to directly buying a call option?

Firstly, the strategy addresses the issue we mentioned earlier, where buyers bear the loss from time decay. By selling a put option, the time value income can offset the time value decay loss from buying the call option, effectively hedging the theta risk.

Secondly, as the risk reversal strategy involves buying a call option while simultaneously selling a put option, it offsets the premium expense of buying the call option. In the case of a rising stock price, the profit is higher compared to solely buying the call option.

Finally, the strategy has a higher success rate than simply buying a call option. Using the previous example, if we only buy a call option with a premium expense of $5.15, we would only profit if Tesla's stock price is above $257.15 (252.5 + 5.15). In contrast, with the risk reversal strategy, profit is achieved with a stock price above $252.84.

The only drawback is that if the speculation is incorrect, the losses in the risk reversal strategy can be higher than in the strategy of solely buying a call option, amplifying delta and gamma risks.

In summary, the characteristics of the risk reversal strategy are high potential returns with limited risk, resilience against time decay, elevated success rate, and amplified profit and loss.

Of course, in practical application, there are several points to consider with this strategy.

2. Points to note in Implementing the Risk Reversal Strategy

1. Incomplete Hedging of Theta Risk: In practice, it's important to recognize that the risk reversal strategy cannot fully hedge theta risk. The purchased call option and the sold put option in this strategy share the same expiration date and strike price (usually at-the-money options). However, under equivalent conditions, the time value of a call option is generally higher than that of a put option. In the example mentioned earlier, the time value of the call option is $5.19, while that of the put option is $4.82. Additionally, the theta coefficient of the call option is greater than that of the put option. Therefore, while this strategy can hedge a significant portion of time value loss, it cannot eliminate it entirely.

2. Margin Utilization: As options sellers require margin, although the risk reversal strategy seems to save on premium expenses, when considering the margin utilized by the seller, it ends up requiring more capital compared to a strategy of simply buying a call option. This indirectly raises the investment threshold.

To sum up, in our Options Cheese Knowledge Column, we have now completed the third installment on advanced strategies. We covered five advanced strategies: the Ratio spread strategy, Butterfly strategy, Iron condor strategy, Calendar spread strategy, and Risk reversal strategy.

It is essential for you to understand how to dynamically hedge using delta values when employing these advanced combination strategies. Recognize the pros and cons of these strategies, understand their suitable scenarios, and learn to use quantitative methods to assess the risk and return of option strategies. Only then can you navigate through practical implementation with ease.

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