The risk reversal options 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.
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.