Using Risk Reversals to position for a year-end rally

26 SEP 2024 | TRADE IDEA | 3 MIN READ

Overview

During the September FOMC meeting, the committee implemented a 50 basis point rate cut and signaled an additional 50bps reduction by year-end. Since the meeting, traders have been increasingly seeking long exposure, fueled by growing consensus around a strong Q4. While various structures are being employed to achieve this, risk reversals have emerged as a popular tool for creating synthetic upside exposure.

Trade Structure: Bullish Risk Reversal (Sell downside): Instrument: Options on CME BTC Futures

Sell 27DEC2024 $55,000 (25-Delta) Put at $3525 per contract – Collect premium from the sale.

Buy 27DEC2024 $85,000 (25-Delta) Call at $2955 per contract – Use the premium collected to finance the purchase of an out-of-the-money call.

Net Credit/Debit: $570 credit per contract

Access: CME Group

CME Bitcoin options offer several practical advantages for this strategy. As a regulated exchange, CME provides institutional traders with a secure and reliable trading environment. The growing liquidity, reflected in the rising average daily volume and open interest, supports smoother execution, especially for larger trades. Furthermore, because these options are based on cash-settled futures, they eliminate the complexity of physical Bitcoin delivery, making them an efficient way to manage Bitcoin exposure.

Key Greeks

Delta: The position starts positive delta, with a 25-delta short put and a 25-delta long call. As the underlying asset rises, the delta turns increasingly positive and benefits the P/L of the whole position.

Gamma: Positive gamma from the long call amplifies delta if the asset price rises, enhancing upside potential.

Theta: The trade is flat to slightly long theta. If the underlying price doesn’t move, the position will benefit from time decay, allowing you to collect the net credit (in this case, $90 per contract) as the short put’s positive theta outweighs the long call’s negative theta.

Payoff Profile

The trade will make money primarily if the underlying asset rises. The long call will gain value as the underlying moves higher, and the gamma will increase the trade’s delta exposure, enhancing the position’s profitability.

The largest risk in a risk reversal strategy is the potential assignment on the short put if the underlying asset’s price drops significantly. If the put option is assigned, you would be obligated to purchase the underlying asset at the strike price, which could be well above the current market price, leading to substantial losses.

In order to mitigate this risk, a trader can choose only to sell the downside put at prices they would happily own the underlying asset.