Nasdaq-100 Index options are a great tool for hedgers and speculators but investors can use them to get exposure to the Nasdaq-100 and can often generate unique risk/return profiles. One such unique profile which is very popular with investors offers the opportunity to buy the Nasdaq-100 at a discount to its current price or at a discount even if it rallies strongly.
We’ve discussed previously that selling an NDX put option can be a great way to buy the Nasdaq-100 at a discount to the current level. Selling that put generates option premium which the investor gets to keep and which generates the discount to the current level if the index falls.
One problem with selling a put option to buy the Nasdaq-100 at a discount is the potential for the index to rally. If the index rallies enough our investor will regret not simply buying the index. Is there a way to use the put option premium collected by selling a put to also get upside appreciation if the index rallies? The answer is “yes”; we could take that premium and buy a call option. This trade structure, short a put option and long a call option, is called a risk reversal and it takes special advantage of an important element inherent in index option prices.
At midmorning on Thursday, January 9, the Nasdaq-100 was at 8994. If an investor wanted to sell an NDX put to collect some premium and potentially buy the index at a discount, she could have sold the 8750 strike put option expiring on March 20th for 162.00. That premium would be the investors to keep but it’s also the maximum potential profit for this trade, as you can see.
If the index rallies to 9156, a gain of 1.8 percent, our investor will regret not simply buying the index.
One way to generate upside potential is to take the option premium generated by selling the put and use it to purchase a call option. Our investor could have bought the 9200 strike call option expiring on March 20th for 144.00. Our investor has still generated net premium of 18.00 (162.00 minus 144.00) which is theirs to keep. But more importantly, our investor now has upside exposure should the Nasdaq-100 rally. You can see this new payoff below.
This payoff profile is unique; it can only be generated using options. Since both strategies involve shorting a put option they’re only appropriate for an investor who is able and willing to buy the index.
The risk reversal will always outperform the Nasdaq-100 if the index falls. The risk reversal will always underperform the index if the index rallies. Our risk reversal generates a small amount of net premium, 18.00, if the index is between the strike prices at expiration.
Observant readers will realize that the put option was slightly more expensive than the call option despite the put option strike price, 8750, being more distant from the at-the-money level, 8994, than the call option strike price, 9200. This is a special phenomenon of index option pricing that the risk reversal takes advantage of.
Index puts tend to be more expensive than index calls, all else being equal, due to buying demand for put options by hedgers and the supply of call options by covered call sellers. A risk reversal takes advantage of this to generate exposure with a tremendous advantage.
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Performance of an index is not illustrative of any particular investment. Index returns quoted represent past performance which is no guarantee of future results.
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