The risk reversal options trading strategy consists of buying an out of the money call option and selling an out of the money put option in the same expiration month. This is a very bullish trade that can be executed for a debit or a credit depending on where the strikes are in relation to the stock.
The investor who enters a risk reversal wants to benefit from being long the call options but pay for the call by selling the put. A trade setup like this eliminates the risk of the stock trading sideways, but does come with substantial risk if the stock trades down.
When to Use a Risk Reversal
The risk reversal has the opposite effect of a collar option strategy. It can protect an investor who is short the underlying asset from a rising stock price. If an investor is worried about the stock price of a short stock position trading higher, they can buy an upside call and then pay for it by selling a downside put. The trade should be executed on a one-to-one basis; for every 100 shares the investor is short, they should execute one risk reversal option contract. If the stock moves higher, the investor would be protected by the upside long call option. If the stock traded lower, the investor would be forced to buy the stock at the short put lower price point.
A risk reversal can also be used as an aggressive bull trade. Because the investor is buying a higher strike price call option and financing the premium paid by selling an out-of-the-money put option, the investor is essentially putting on a bull trade for close to no cost or even a credit. If the investor is correct, and the stock continues to trade higher, the short put will become worthless and the long call will increase in value-generating a considerable profit.
However, if the investor is incorrect about the stock movement, they will be forced to buy the stock at the short put strike price. Although this is extremely risky and can generate significant losses. Being forced to buy the stock lower than where the investor initially opened the risk reversal is still a better outcome than if they just would’ve purchased the stock from the start.
The maximum profit is unlimited as being long an upside call allows the investor to continue to make money as the stock trades higher.
The maximum loss is also unlimited, at least down to zero, as the stock falls in price losses continue to build upon the short put.
A risk reversal has a single breakeven point but is calculated differently depending on if the risk reversal was executed for a credit or a debit.
If the risk reversal was acquired for a credit, the breakeven would be calculated by subtracting the premium received from the put’s strike price.
If the risk reversal was acquired for a debit, the breakeven would be calculated by adding the amount paid to the call’s strike price.
If XYZ is trading $100 and is expected to trade higher over the next year, a trader could buy a 120-strike price call and sell an 80-strike price put for the following price:
- Buy 1 XYZ 120-strike price call for $6.00
- Sell 1 XYZ 100-strike price put for $$7.00
- Total premium = $1.00 credit
If the stock trades up to $105 at expiration, the investor will have a zero gain, as the stock has not reached the strike price, but because the investor received a $1.00 credit on the risk reversal, they will have a net profit of $1.00.
If the stock trades up to $130 at expiration, the investor will have a $10.00 gain on the call, as the stock has exceeded the 120-strike price by $10. However, because they received a $1.00 credit for the risk reversal, the investor will have a net gain of $11.00.
If the stock trades down to $70 at expiration, then the trader will get assigned on the 80-strike price put, being forced to buy the stock for $80. This would mean they took a $10.00 loss on the put, but because they received a credit of $1.00 for the risk reversal, they would have a net loss of $9.00.
The risk reversal is a position that has an extremely high-profit potential if executed correctly, but if wrong, can generate significant losses for an investor.
This type of trade has very little sensitivity to changes in implied volatility as it is short one option and long another.
A risk reversal is not a strategy for a beginner, as losses can be large if the trade moves against the investor. It is only recommended for experienced options traders.