Risk reversal option strategy is a term applied to an option hedging strategy used for protecting either a long or short position. It does so by using either call or put options. The idea is to protect against unexpected price movements in your underlying position but the strategy comes at a price. It typically limits the profit that your initial position can generate. An example of a risk reversal option strategy with a long position in a stock would be to buy a put option and sell a call option. There are several variations of this approach.
Why Is It Called a Risk Reversal?
The term risk reversal is used for several option strategies because they reverse the so called volatility skew risk that options traders constantly contend with. In general, OTM puts have greater implied volatilities and are more expensive than OTM calls. This is because there is commonly a greater demand for puts to protect long stock positions. In a risk reversal strategy the trader sells an option with higher implied volatility and buys one with a lower implied volatility thus reversing the volatility skew risk.
Risk Reversal Applications for Speculation
When a risk reversal strategy is used for speculation it is used to create either synthetic long or short positions. There are two basic variations when speculating. The first is to write an OTM put and buy an OTM call. This gives you the equivalent of a synthetic long position which has the same risk to reward profile as a long position in a stock. Being a bullish risk reversal it profits when the stock rises sufficiently and is not profitable when and if the stock falls in price.
Risk Reversal Applications for Hedging
When a risk reversal strategy is used for hedging it reduces the risk of an existing short or long position. In this case you will write an OTM call and buy an OTM put. This gives you the equivalent of a synthetic short position with a risk to reward profile like a short position in the stock. It is a bearish risk reversal strategy that profits when the stock goes down sharply and is unprofitable when the stock appreciates in price. This approach is also referred to as a collar and when applied under appropriate circumstances is a “costless collar.” In other words, it can be possible to protect a position without incurring any up-front cost. When you write an OTM put and buy an OTM call, this approach hedges a short position and can also be set up without any up-front cost.
When Should You Use a Risk Reversal Option Strategy?
There are four typical reasons for using a risk reversal strategy. The first is that that you really like a stock but need some leverage. By writing an OTM put you will earn a premium which you can apply to purchasing an OTM call thus giving you access to a stock position that was otherwise to pricey for you.
The second situation in which you may use this strategy is in the early part of a bull market. This is when good stocks typically surge in price and the risk of assignment is minimal. Meanwhile the potential for significant profit as the market and your stock move upward is strong.
Another place to use a risk reversal option strategy is before imminent stock splits or spinoffs. At these times there is typically a lot of investor enthusiasm which will give you good downside support and can result in impressive gains. Some traders consider this to be the perfect environment for applying this strategy.
And, when there is a bull market but a blue chip stock misses earnings estimate and falls “out of favor.” When you doubt that the current market sentiment about this stock will last, a risk reversal strategy with expiration dates at about six months can provide very nice returns if the stock rebounds as you expect.