Risk Reversal Strategy - Is Now The Time To Get Your Feet Wet?

Tech stocks can be the darlings of one portfolio. They’re also the stocks that tend to nosedive the fastest when the markets sense a problem. One only needs to compare the S&P 500 average with the Nasdaq 100. YTD, the S&P 500 is down 15.1%, while the Nasdaq 100 is down almost 23% as increasing interest rates force highly leveraged companies (such as those on the Nasdaq 100) to borrow at higher costs. In turn, the thought is that these same companies will pull back on investments, leading to (lower) future profits.

Furthermore, the first half of 2022 has seen a deterioration in almost every market. I mean, it’s not every day that you see pretty much everything (including their Shiba Inu) sell off. Indeed, not hitting the sell button during 1H22 ought to be an Olympic sport. 

But, what do you do if you did hit that sell button? You already know that thanks to inflation, cash is a terrible investment. But, now that Fed Chairman Jerome Powell said we’re not in a recession, and markets are starting to position themselves to the upside. So, is now the right time to put that cash to work? Perhaps.

Nasdaq QQQ Invesco ETF (QQQ)

As mentioned, when there’s fear, tech stocks tend to underperform the S&P 500. Fortunately, the same can be said in reverse. When there’s optimism in the air, Nasdaq companies tend to overperform. For example, if we compare the 1M return of both indices, we’ll see that the S&P 500 gained 6.64% vs. the Nasdaq 100’s 9.09% return. Putting it differently, the Nasdaq 100 outperformed the S&P 500 by 36.8% over the past month.

Investors can leverage current sentiment by using the options market with a risk reversal strategy. And for that, we’ll focus on the Nasdaq QQQ Invesco ETF.

The Nasdaq QQQ Invesco ETF is a popular investment choice for those looking to track the performance of the Nasdaq-100 Index, which is made up of the 100 largest nonfinancial stocks that trade on the Nasdaq exchange. This makes it a good option for those who want to invest in tech stocks. 

Risk Reversal Strategy

Generally, a risk reversal strategy involves selling a covered call and buying a put with the premium received. But for this article, we’re doing to turn the idea on its head. 

Let’s assume the trader is bullish in the direction of the Nasdaq 100. A trader could sell a cash-secured put option and use the collected premium to buy a call option. In this case, investors who believe that the Nasdaq 100 Index is trending upwards can consider selling an OTM put option on the QQQ and simultaneously use that cash to buy an OTM call option on the same ETF.

The trade

Investors can review Barcharts’ Trader’s Cheat Sheet for the QQQ ETF to get a clearer idea of the support and resistance points. The “Trader’s Cheat Sheet” link is in the left-hand sidebar under the “Technicals” section. Here we can see the QQQ’s 3rd resistance point ($320.21) and support point ($297.25). 

Using this data, we can look to sell a monthly put option that expires Oct 21, 2022, and buy a call option with the same expiration date. In this case, a trader might consider selling the $298 strike and collect a $10.62 premium. At the same time, the trader might buy the $322 call option for an $11.95 premium resulting in a net debit of $1.33 (Or $133 per contract). 

One thing to note is that the trader must have enough margin to execute the trade. This is because should the QQQ trade below $298 at expiration, the trader will need to buy 100 shares of the QQQ times the number of contracts sold to the option buyer. In other words, should the option get exercised, the investor would get to buy 100 shares of the QQQ at a roughly 4% discount from yesterday's close.

Of course, if sentiment changes, and should the QQQ approach $298, the trader could roll the option to a further expiration date. Doing so will shield the trader from further downside (like kicking the can, hoping for a better outcome in the future).

That said, if the trader gets the direction right, they get to participate in all the QQQ’s upside over $322 from now until expiration - which is also just 4% higher than the last closing price. And considering the market’s momentum, it could result in a giant payday at expiration.

More Stock Market News from Barchart

• Long Straddle Screener Results For July 29th
• Farfetch Could Be the Best Consumer Cyclical Stock to Buy Now
• Stocks Rally on Speculation the Pace of Fed Rate Hikes May Slow
• Meta Platforms Reports its First-Ever Sales Decline - Shares Plunge