Married Puts, Fiduciary Calls & Risk Reversal Strategies

Married Puts

The married put is a strategy that's used for hedging purposes when investing in stocks. It's actually very similar to the protective put, another hedging strategy, but there are some key differences between these two strategies. Primarily, these are the reasons for using each strategy and the point at which they are used.

The protective put is used to protect profits that have already been made from a long stock position, and ones that would be used at some point after the long stock position has been established and the price has gone up. The married put, however, is used to limit potential losses from a long stock position and is used at the same time as entering a long stock position.

A trader would typically use a married put as a form of insurance when buying stock, to cover any potential losses should the price of the stock fall instead of going up. There's a cost associated with taking that insurance, but the married put essentially offers the best of both worlds: the potential for unlimited profit should the stock price go up and limited downside should it go down.

It's a really easy strategy to use too; you simply buy enough at the money put options to cover the shares you are buying. The cost of these options is basically the cost of using the married put, but if the stock does go down in value, then you can exercise your option to sell the stock at the price you paid for it.

If the stock goes up then, providing the increase in the price of the stock is greater than the cost of the puts, you will make a profit. The only real downside of the married put is that the cost will eat into those profits a bit and if the price of the stock doesn’t move at all you will lose the money you spent on the options. However, that's the price you pay for limiting your potential losses.

Fiduciary Calls

The fiduciary call is very similar to a simple long call, in that the only transaction involved is buying call options. In many respects it's also similar to a stock replacement strategy, in that it is used as an alternative to buying stock, although the real purpose of it is essentially to reduce the costs involved in buying and exercising call options instead of buying stock.

To create a fiduciary call you would buy at the money calls based on a stock that you wish to invest in. You would then invest the balance of the capital that would be required if you were actually buying the stock and putting it into a risk free interest bearing account. As an example, let’s say you were thinking about buying one thousand shares of Company X stock when it's trading at $25 but decide to use a fiduciary call instead.

In the money calls on Company X stock, with a strike of $25, are trading at $2, so you spend $2,000 to cover one thousand shares instead of the $25,000 you would need to spend on actually buying one thousand shares directly. This leaves a balance of $23,000 compared to what it would have cost for you to buy the shares.

You would then invest the $23,000 into some form of interest bearing account. The idea is that, by the time the options expire, you'll have made enough interest to at least partially cover the cost of buying them. Therefore if they expire worthless you will have offset some of the losses, and if they expire in the money you will have offset some of the cost of exercising them: thus increasing your profits.

Really, the fiduciary call is just about putting your capital to good use if you choose to buy call options based on a stock rather than actually buying that stock.

Risk Reversal

Risk reversal can actually be used to mean two different things in an investment sense. It's a term used, typically in forex options trading, to describe the difference in volatility between call options and put options. When the term risk reversal is used in this way it's not a trading strategy, but it's a measurement that can be used as a way of evaluating sentiment in the market.

When there's positive risk reversal (i.e. calls are more expensive than puts), it suggests that the market on the underlying security is generally bullish. When there's negative risk reversal (i.e. calls are cheaper than puts), it suggests that the market on the underlying security is bearish.

The term risk reversal can also be used to describe a hedging strategy, commonly used by commodities traders, to protect against potential unfavorable price movements in an owned asset. The risk reversal strategy is used by selling out of the money calls and buying out of the money puts options based on an underlying security that is already owned.

Risk of the security falling in value is then limited, because if it falls below the strike price of the put options, they will make enough profit to cover any further losses. However, the flip side is that it limits profits if the security goes up in price. If the security rise above the strike price of the call options, then the underlying security could be called away.

Therefore the risk reversal strategy is best used if you own an asset that you think will increase moderately in price, but you want to limit your losses should it fall in price. The strategy shouldn't cost anything to put on, because the idea is that the cost of the puts you buy should be covered by the money received for writing the calls.