There’s been an awakening. Have you felt it?

Small-caps were surging on Wednesday as everyone from airlines and cruise lines to casinos and retail took flight. It could have been called the “reopening rally,” since the most economically sensitive stocks were the biggest winners. Credit for the sudden surge in the little guys goes to the New England Journal of Medicine for publishing glowing data surrounding Moderna’s coronavirus vaccines efficacy.

The impressive showing from these industries is something we haven’t seen in a long time. For weeks, tech has been the best game in town. But on Wednesday, while the Russell 2000 Index (RUT, IWM) was up nearly 4%, the Nasdaq ETF (QQQ) was unchanged. That’s huge, HUGE, outperformance. And it’s healthy. It signals a broadening of the rally.

Suppose I’m looking to bottom fish in one of the beaten-down, but now surging names. UAL, CC, SEAS, AAL, and MGM all topped the leaderboard yesterday. I think a risk reversal strategy could be appropriate.

Risk Reversal

Don’t get confused or distracted by the fancy name. A risk-reversal is nothing more than a naked put and a long call. It’s a combo trade. You can think of it in one of two ways:

By adding a long call to a naked put, I’m turning a limited reward trade into an unlimited one.

By adding a naked put to a long call, I’m lowering the breakeven and creating a position with a higher probability of profit.

Risk-Reversal Logic

Take MGM, for instance. Wednesday’s 13% rip generated a breakout above horizontal resistance and both the 50-day and 20-day moving averages.

With the stock at $18.20, let’s say we sold the Aug $17 put for $1.60 while buying (2) Aug $23 calls for 80 cents apiece. Essentially, the credit received from the put financed the two OTM call options.

Keep in mind, even though it looks like a no-cost trade, you will have to put up the required margin for the naked put. Here is the risk graph:

If the stock sits between $17 and $23 at expiration, you will breakeven. But if it runs toward $22 and beyond quickly, then you could score a substantial profit.

You could modify the structure slightly if you want to capture a profit if the stock stagnates. Sell the Aug $17 put for $1.60 but only buy one Aug $23 call for 80 cents. That way you’re left with an 80 cent credit that serves as your profit if we end up between $17 and $23. It will also shift the lower breakeven price from $17 to $16.20.

Technically this bullish risk reversal is a +3 type trade on our bias spectrum due to the OTM long calls purchased. However, it has a much better breakeven than a straight long call because of the addition of the naked put.

Management Ideas

If MGM bites the dust, you could do one of two things. First, exit the entire trade if we break the $15.30 support zone. Second, if you like the stock long-term, you could allow assignment and get put the stock.

If MGM rips higher, you again have multiple choices. First, I would plan on buying back the put when you capture the majority of the profit. Second, I would exit the calls when you think the next upswing is topping out. Remember, you are long one-month OTM calls. Time decay will eat these alive if you overstay your welcome.

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