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The potential for a big payoff for very little premium is the inherent attraction of a risk reversal strategy. Risk reversal strategies are widely used in the forex and commodities options markets. But, they tend to be used primarily by institutional traders and seldom by retail investors when it comes to equity options. Risk reversal strategies may seem a little daunting to the option neophyte, but they can be a very useful option for experienced investors who are familiar with basic puts and calls.
Key Takeaways
- Risk reversal is a hedging or speculation strategy that options traders use to protect their long or short positions using put and call options.
- This strategy reverses the volatility skew risk a trader experiences.
- The most basic risk reversal strategy involves writing an out-of-the-money put option and buying an OTM call option at the same time.
What Is Risk Reversal?
The most basic risk reversal strategy consists of selling (or writing) a put option that is out-of-the-money (OTM) and simultaneously buying an OTM call. This is a combination of a short put position and a long call position.
Since writing the put results in the trader receiving a certain amount of premium, this premium income 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.
But if the premium received from writing the put is greater than the cost of the call, the strategy generates a net credit. If 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.
The reason why it’s called risk reversal is that it reverses the volatility skew risk a trader usually confronts. Put simply, OTM puts typically have higher implied volatilities (and are thus more expensive) than OTM calls, because of the greater demand for protective puts to hedge long stock positions. Since a risk reversal strategy generally entails selling options with a higher implied volatility and buying options with a lower implied volatility, this skew risk is reversed.
Applications of Risk Reversal
Risk reversals can be used for speculation or hedging. When used for speculation, a risk reversal strategy can simulate a synthetic long or short position. When used for hedging, a risk reversal strategy is used to hedge the risk of an existing long or short position.
The two basic variations of a risk reversal strategy used for speculation and hedging are noted in the following tables.
| Risk Reversal Strategy for Speculation | ||
|---|---|---|
| Write OTM Put | Buy OTM Call | This is equivalent to a synthetic long position since 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. |
| Write OTM Call | Buy OTM Put | This is equivalent to a synthetic short position, as the risk-reward profile is similar to that of a short stock position. This bearish risk reversal strategy is profitable if the stock declines sharply, and is unprofitable if it appreciates significantly. |
| Risk Reversal Strategy for Hedging | ||
|---|---|---|
| Write OTM Call | Buy OTM Put | This is used to hedge an existing long position and is also known as a collar. A specific application of this strategy is the costless collar, which enables an investor to hedge a long position without incurring any upfront premium cost. |
| Write OTM Put | Buy OTM Call | This is used to hedge an existing short position, and as in the previous instance, can be designed at zero cost. |
A collar is an options strategy that traders use to protect against major losses in the face of short-term volatility in the market. Traders often use collars when they are optimistic about the long-term prospects of the asset. Collars also limit the potential for future gains.
When to Use Risk Reversals
There are some specific instances when risk reversal strategies can be optimally used. We’ve noted some of the most common times below.
Favor a Stock, Need Leverage
Risk reversal strategies are useful when you like a stock but require some leverage. If you like a stock, writing an OTM put on it is a no-brainer strategy if:
- You do not have the funds to buy it outright, or
- The stock looks a little pricey and is beyond your buying range
In this case, writing an OTM put will earn you some premium income, but you can double down on your bullish view by buying an OTM call with part of the put-write proceeds.
In a Bull Market
Good quality stocks can surge in the early stages of a bull market. There is a diminished risk of being assigned on the short put leg of bullish risk reversal strategies during such times, while the OTM calls can have dramatic price gains if the surge of the underlying stock.
Before Major Events
These major events include spinoffs and others like an imminent stock split. Investor enthusiasm in the days before a spinoff or a stock split typically provides solid downside support and results in appreciable price gains, the ideal environment for a risk reversal strategy.
Blue Chip Drops in Bull Markets
Risk reversal strategies come in handy when a blue chip company’s stock abruptly plunges, especially during strong bull markets.
During strong bull markets, a blue chip that temporarily falls out of favor because of an earnings miss or some other unfavorable event is unlikely to stay in the penalty box for very long.
Implementing a risk reversal strategy with medium-term expiration (say six months) may pay off handsomely if the stock rebounds during this period.
Advantages and Disadvantages of Risk Reversals
Advantages
Risk reversal strategies come at a low cost. As such, they can be implemented with little to no expense by the trader.
There is also a favorable risk-reward profile associated with risk reversal strategies. While not without risks, these strategies can be designed to have unlimited potential profit and lower risk.
Traders can use risk reversal strategies in a wide range of situations. This means that reversals aren’t just for complex or specific trading strategies. Rather, you can use reversals in any number of trading scenarios.
Disadvantages
- Margin requirements can be onerous. Margin requirements for the short leg of a risk reversal can be quite substantial.
- There is a substantial risk on the short leg. The risks on the short put leg of a bullish risk reversal, and the short call leg of a bearish risk reversal, are substantial and may exceed the risk tolerance of the average investor.
- Doubling down. Speculative risk reversals amount to doubling down on a bullish or bearish position, which is risky if the rationale for the trade proves to be incorrect.
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Substantial margin requirements
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Big risk on the short leg
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Doubling down on bullish or bearish position
Examples of Risk Reversal
Let’s use Microsoft (MSFT) to illustrate the design of a risk reversal strategy for speculation, as well as for hedging a long position.
Let’s assume that Microsoft closes at $41.11 in June. At that point, the MSFT October $42 calls were last quoted at $1.27 / $1.32, with an implied volatility of 18.5%. The MSFT October $40 puts were quoted at $1.41 / $1.46, with an implied volatility of 18.8%.
Speculative Trade
This type of trade involves a synthetic long position or bullish risk reversal. Now let’s take a look at an example using the information about Microsoft noted above.
- Write 5x the MSFT October $40 puts at $1.41, and buy 5x the MSFT October $42 calls at $1.32.
- Net credit (excluding commissions) = $0.09 x 5 spreads = $0.45.
Note these points:
- With MSFT last traded at $41.11, the $42 calls are 89 cents out-of-the-money, while the $40 puts are $1.11 OTM.
- The bid-ask spread has to be considered in all instances. When writing an option (put or call), the option writer will receive the bid price, but when buying an option, the buyer has to shell out the ask price.
- Different option expirations and strike prices can also be used. For instance, the trader can go with the June puts and calls rather than the October options if they think that a big move in the stock is likely in the 1.5 weeks left for option expiry. But while the June $42 calls are much cheaper than the October $42 calls ($0.11 vs. $1.32), the premium received for writing the June $40 puts is also much lower than the premium for the October $40 puts ($0.10 vs. $1.41).
What is the risk-reward payoff for this strategy? Very shortly before option expiration on Oct. 18, there are three potential scenarios concerning the strike prices:
- MSFT is trading above $42: This is the best possible scenario since this trade is equivalent to a synthetic long position. In this case, the $40-strike puts will expire worthless, while the $42 calls will have a positive value (equal to the current stock price less $42). Thus if MSFT has surged to $45 by Oct. 18, the $42 calls will be worth at least $3. So the total profit would be $1,500 ($3 x 100 x 5 call contracts).
- MSFT is trading between $40 and $42: In this case, the $40 put and $42 call will both be on track to expire worthless. This will hardly make a dent in the trader’s pocketbook, since a marginal credit of nine cents was received at trade initiation.
- MSFT is trading below $40: In this case, the $42 call expires worthless, but since the trader has a short position in the $40 put, the strategy will incur a loss equal to the difference between $40 and the current stock price. So if MSFT has declined to $35 by Oct. 18, the loss on the trade is equal to $5 per share, or a total loss of $2,500 ($5 x 100 x 5 put contracts).
Hedging Transaction
Assume the investor already owns 500 MSFT shares and wants to hedge downside risk at a minimal cost. (This is a combination of a covered call + protective put).
- Write 5x the MSFT October $42 calls at $1.27, and buy 5x the MSFT October $40 puts at $1.46.
- Net debit (excluding commissions) = $0.19 x 5 spreads = $0.95.
What is the risk-reward payoff for this strategy? Very shortly before option expiration on Oct. 18, there are three potential scenarios concerning the strike prices:
- MSFT is trading above $42: In this case, the stock will be called away at the call strike price of $42.
- MSFT is trading between $40 and $42: In this scenario, the $40 put and $42 call will both be on track to expire worthless. The only loss the investor incurs is the cost of $95 on the hedge transaction ($0.19 x 100 x 5 contracts).
- MSFT is trading below $40: Here, the $42 call will expire worthless, but the $40 put position would be profitable, offsetting the loss on the long stock position.
Why would an investor use such a strategy? Because of its effectiveness in hedging a long position that the investor wants to retain, at minimal or zero cost. In this specific example, the investor may have the view that MSFT has little upside potential but significant downside risk in the near term. As a result, they may be willing to sacrifice any upside beyond $42, in return for obtaining downside protection below a stock price of $40.
What Does Risk Reversal Mean?
The term risk reversal refers to a strategy that traders use to protect their short or long positions by using call and put options. The most basic type of risk reversal strategy is writing an out-of-the-money put option and buying an OTM call at the same time. This speculation or hedging strategy provides traders with a way to protect themselves against adverse price movements in the underlying asset. But it also limits the degree of profits that the trader can earn on their position.
What Is a Collar?
A collar is a strategy used by options traders. It is a risk reversal strategy that both limits losses and gains. Traders use collars for an asset whose value is higher than the price at which they purchased it, and when their long-term outlook is positive in the face of short-term volatility. Using a collar involves buying a put as a way to cushion against put drops and sell a call to generate some immediate profit.
How Do You Trade Options?
Options are complex financial contracts that give buyers the right (but not the obligation) to buy or sell a financial asset at a specific price on or before the expiry date. Options come in calls (allows the buyer to buy the underlying asset) and puts (allows the buyer to sell the underlying asset). Traders can use options for any type of security, including stocks, bonds, indexes, and exchange-traded funds (ETFs), Owning an options contract doesn’t provide the holder any benefits of the underlying asset. Options give traders a chance to hedge against drops in the price of the underlying asset, speculate on changes in its price, and generate income at the same time.
The Bottom Line
Options can be complicated investments, so they’re not designed for the novice investor. That’s because there are so many intricacies involved. You need to have a deep understanding of how they work to reap the benefits associated with them. Once you get the hang of them, the highly favorable risk-reward payoff and low cost of risk reversal strategies enable them to be used effectively in a wide range of trading scenarios.