If you’ve been on the sidelines for the past few months or maybe even longer then you’ve missed most of a substantial market rally and now we’re in the midst of a market correction. If this is the case and you’re a disciplined investor then you’ve been patiently waiting for the right opportunity to get back in. If this sounds like you then perhaps a risk reversal may be a strategy that makes sense for you.

Firstly, if you’ve managed not to get too jumpy and buy some of the recent small dips, congratulations your reward is a chance to buy some of the stocks on your wish list for 10-20% cheaper. Unfortunately, the eternal question remains the same, “is the bottom or will the market drop even lower?” Unfortunately, no one has the answer to that question but what this strategy does is provide you with a little leigh way in the event the bottom isn’t quite here yet. It also provides the scenario that you make some free money while not getting into the market at all. Here’s how it works.

Now we must assume you have some basic knowledge of the basic market tools or perhaps this isn’t for you. Assuming that the prerequisite has been met, we will start with an index position even though this strategy is most often implemented when dealing with individual stocks. However we’re talking today about getting back into the market as a whole after being on the sidelines so we be using a basic ETF or exchange traded fund. ETFs allow you to blanket an entire index or sector with one security that trades on a daily basis. For this example we will you the IShares S & P 500 index fund, the symbol is IVV. On an individual stock basis we are looking at NVIDIA(NVDA). Let’s start with the basics of what a risk reversal is, the most basic risk reversal strategy consists of selling (or writing) an out of the money(OTM) put position and simultaneously buying an OTM call. This is a combination of a short put position and a long call position. Since writing the put will result in the option trader (you) receiving a certain amount of premium, the income from the transaction can be used to buy the call. If the cost of buying the call is greater than the premium received for writing the put, the strategy would involve a net debit. Conversely, if the premium received from writing the put is greater than the cost of the call, the strategy generates a net credit. In the event that the put premium received equals the outlay for the call, this would be a costless or zero-cost trade. Of course, commissions have to be considered as well, but in the examples that follow, we ignore them to keep things simple.

We are using this strategy because we found a stock that we want to purchase but would like some kind of protection in the event the stock continues to go down, in current market conditions that means that we haven’t seen the bottom of the correction yet. So we ae going to use this to create a net long position on IVV by writing an out of the money (OTM) Nov 25 Put at 265 for 5.50  and simultaneously buying  Buy OTM Call (same duration) at7.30; this is equivalent to a synthetic long position. Since we want to own the stock for our portfolio, the risk-reward profile is similar to that of a long stock position. Known as a bullish risk reversal, the strategy is profitable if the stock rises appreciably, and is unprofitable if it declines sharply.

It may seem like a lot of moving the furniture around to have a simple long position on a stock but if the stock remains in the same position then there is no profit or loss so we are no worse off. If it declines slightly then the put will expire worthless and we keep the premium as profit. If it declines sharply then we will have our put executed and we will own the stock we wanted anyway but at a lower price  than we would have originally bought it for. If NVDA rises sharply and we de did call a good bottom in the stock then we can execute our call and own the stock outright. Lastly, if we get cold feet and think the rally may be a bit of ‘fool’s gold’ we could also sell the call to someone at the current market price and keep the profit then run the same strategy again. In any case if the decision to get off the fence is made this is a smart way of entering a volatile market. We’ll follow up in a couple of weeks and revisit the trade to see how it is performing.