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Risk Reversal: Summary
Risk Reversal - Introduction
Risk reversal is an options trading strategy that aims to put on a free options position, which is one where you neither pay nor receive upfront payment (credit), for the purpose of leveraged speculation or stock hedging.
Risk reversal is a little known strategy in the stock options trading scene but a pretty common term in the forex options trading scene and the commodities options trading scene for its hedging power, hence the name "Risk Reversal". Even though the name makes the strategy sound very sophisticated, it really is a very simple options strategy with a very simple underlying logic.
This tutorial shall explain what Risk Reversal is in options trading and describe in detail all the different applications of Risk Reversal.
What Is Risk Reversal?
As the name suggests, Risk Reversal is a technique for the reversal of risk using options. This means that it is inherently a hedging strategy even though it can also be used for leveraged speculation.
What makes risk reversal different from most leveraged speculation or hedging strategies is the fact that risk reversal aims to perform hedging or speculation without any additional capital outlay. This is why risk reversal is so popular in commodities options trading as a means of guaranteeing a certain price range without any additional cost (apart from commissions).
Risk Reversal can also used as an investor sentiment gauge. When a risk reversal position is selling for a net debit (what is known as a "Positive Risk Reversal"), it means that call options are more expensive than put options due to higher implied volatility of call options. This implies a bullish sentiment on the underlying asset. When a risk reversal position is selling for a net credit (what is known as a "Negative Risk Reversal"), it means that put options are more expensive than call options due to higher implied volatility of put options. This implies a Bearish sentiment. In fact, in forex options trading, risk reversals are directly quoted based on implied volatility so that its even easier to see which way investor sentiment is inclined towards.
How To Use Risk Reversal?
Risk Reversal uses the sale of one out of the money call or put option in order to finance the purchase of the opposite out of the money option ideally at zero cost. This means that Risk Reversal can be executed in two ways:
Buy OTM Call + Sell OTM Put
Risk Reversal for Leveraged Speculation
When executed on its own as a leveraged speculation position, Buying OTM call + Selling OTM put creates a Bullish speculation position (see the Risk Reversal Bullish risk graph at the top of the page) while buying OTM put + selling OTM call creates a bearish speculation position (see the Risk Reversal Bearish risk graph at the top of the page). Both risk reversal positions have unlimited profit and unlimited loss potential as if you are trading the underlying stock itself, the only difference being that no cash is paid for this position (ideally) and that there is a small price range between the strike price of the options involved where neither profit nor loss is made as you can see from the risk graphs at the top of the page.
In fact, buying OTM call + selling OTM put creates a synthetic long stock position, which is an options trading position with the same characteristics as owning the underlying stock itself (buts pays no dividends of course). Conversely, buying OTM put + selling OTM call creates a synthetic short stock position, which is an options trading position with the same characteristics as shorting the underlying stock.
Even though using risk reversal for leverage results in a position that ideally requires no capital outlay upfront, it does involve margin as the short leg of the position is a naked write. The margin required may in fact tie up more funds during the life of the position than if you had simply bought call or put options for the same speculation.
For instance, you could simply tie up only $75 by buying one contract of the call options above in order to speculate on XYZ going upwards instead of the thousands of dollars with the inclusion of the short leg. A bit of legging may also be needed in order to drive both prices closer to each other.
Risk Reversal for Hedging
Risk reversal was designed as a hedging strategy in the first place and is most commonly used in stock options trading for hedging a stock position by buying OTM put and selling OTM call. This creates a Covered Call Collar strategy which prevents the stock from losing value beyond the put option strike price and allows the stock to appreciate up to the strike price of the short call options.
Risk reversal can also be used to reverse risk out of short stock positions by buying OTM call and selling OTM put.
Choosing Strike Prices for Risk Reversal
Ideally, out of the money call and put options with strike prices of the same distance to the stock price should be of the same price due to put call parity.
For instance, if the underlying stock is $44, call options which are $1 out of the money ($45) and put options which are $1 out of the money ($43) should be of the same price as in the examples above.
However, not only does put call parity rarely exist in such perfection, call and put options are also rarely exactly the same distance from the stock price since stock price is moving all the time. As such, put options and call options with strike prices of the same (or almost same) distance from the stock price are rarely the same price. In fact, in strong trending market conditions, the difference in price between call and put options can be very significant. As such, it may be almost impossible to put on Risk Reversal positions for exactly zero cost in practise. Also, out of the money call options and put options with almost the same price may be of a different distance from the stock price. As such, options traders practising risk reversal in reality don't always put it on with call and put options that are of equidistance from the stock price.
The most important point in executing a Risk Reversal is to be able to put on the position with zero or very near zero cost. As such, you should choose the strike prices which are selling for almost the same price instead of aiming for equidistance.
The picture below is the actual options chain for QQQQ at $44.74. As you can see, the out of the money call and put options that are of almost the same price and therefore good for Risk Reversal isn't equidistant from the stock price of $44.74.
Trading Level Required For Risk Reversal
A Level 5 options trading account that allows the execution of naked options writing is needed for the Risk Reversal. Read more about Options Account Trading Levels.
Profit Potential of Risk Reversal:
When risk reversal is used for leveraged speculation, it will make an unlimited profit and an unlimited loss as if you bought or shorted the underlying stock itself. When risk reversal is used for hedging, the underlying stock would make a maximum profit limited by the strike price of the short leg and a maximum loss limited by the long leg.
Profit Calculation of Risk Reversal:
There is no limit to the profit potential of Risk Reversal when used for leveraged speculation and since no money is paid for the position, the return on investment is infinite.
Risk / Reward of Risk Reversal:
When Used For Leveraged Speculation
Maximum Profit: Unlimited
Maximum Loss: Unlimited
Break Even Points of Risk Reversal:
When used for leveraged speculation, Risk Reversal makes a profit when the underlying stock rises (or falls) beyond the long leg and makes a loss when the underlying stock falls (or rises) beyond the short leg.
Advantages Of Risk Reversal:
:: Can be used for both hedging and speculation
:: Can be performed at ideally no extra cost
:: Unlimited profit potential
Disadvantages Of Risk Reversal:
:: Margin needed.
:: Unlimited loss potential
Alternate Actions for Risk Reversal Before Expiration :
1. If the position is already profitable prior to expiration, the position can be closed by closing out both legs individually.