Simplifying what a reversal combination is would be to have you think of the tactic as an almost risk-less way to create capital out of proverbial thin air. That almost riskless assumption hinges on, for the most part, interest rates remaining static. Capital creation comes in the form of cash. That cash is gained from selling the underlying stock short which is executed in order to complete the reversal combination.
Now, here is where things might get a bit tricky for some, if not completely causing an epiphany for others. Any capital in an account does not idly sit there. And if the trader or firm does not demand to be paid interest on their short account credit balance, that is their prerogative. But, a brokerage firm housing their account and thus capital will gladly take that interest as they lend out that newly created capital generated by clients who sold stock short no matter how small the interest paid to them might be.
Short enough stock and that interest accrued on a daily basis begins to add up to serious cash. Folks on the collecting side of that equation got quite used to receiving rather large monthly checks for their credit balances generated by reversals. Interest rates had risen from 1980 on, thanks totally to Fed Chairman Paul Volcker. However, things change and interest rates were to do just that in August of 1982.
That time, August of 1982, Fed Chairman Volcker wisely thought that he could begin to start the great unwind in interest rates that began in 1980 as inflation began to recede rather quickly. I still recall the big banks cutting the then prime rate so quickly. On one particular day that late summer of 1982 the prime rate was cut twice in one day by a half point for each cut. The prime rate then was in the high teens, so plenty of room was available to make those rather staggering reductions.
Well, reversals do not like any reduction in assumed interest rates. Begin cutting those rates by full points and you can create chaos and panic akin to the infamous Flash Crash. Shock and awe was the prevailing emotion in the options world at that time as literally everyone with reversals in position had to unwind them, or else.
Now, think about what a reversal that must be unwound in a hurry entails. First, the long calls must be sold, the shorted puts must be covered and -- the shorted stock has to be bought back. Doing all three trades at once is a pure art form. Doing all 3 trades profitably when the entire market is attempting the same things and you have macro chaos. Creating that situation in the very early years of options trading, when nobody ever had experienced massive unwindings of reversals catalyzed the biggest short squeeze in percentage terms in stock market history. That short squeeze, which began in early August of 1982, with the S&P 500 around 100, finally began to exhaust itself by June of 1983. By then the S&P 500 was nearing 170, a 70% bull market run in a mere 10 months!
In today's numbers, in order to feel what we felt as those experienced in this massive bull run, the S&P 500 would have to rally from the current 1500 level to over 2500, doing so by December. As for the Dow, that index would be almost 24,000 by this December. Part two will focus on the current status of the short interest and what it might portend. Here is a hint: we may already be well into this generation's big squeeze and not even know it!
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