Introduction

A risk reversal is a combination of options. As such, a risk reversal is an example of an option strategy. In this writeup, we will see how a risk reversal is built, what the potential profit and risks are. This writeup assumes the reader is familiar with what an option is.

How to build a risk reversal

A risk reversal consists of two options with the same time to expiry on the same underlying. The first option is a short out the money call, and the second is a long out the money put. This means that the strike of the put is lower than the call. Normally, the strikes of the risk reversal are both equally far from the current price of the underlying. This strategy has the following payoff at expiration
  • Below the strike of the put: The call is worthless, and the long in the money put has a value of 1 for each 1 the underlying is below the the strike.
  • Above the strike of the put, but below the strike of the call: All options expire worthless.
  • Above the strike of the call: The put is worthless, but the short call is not. As such, the value is -1 for each 1 the underlying is above the strike.

A risk reversal in this form is a bearish strategy. It is, of course, equally possible to set up the opposite trade if one is bullish; by being long the call and short the put, one profits from an increase in the underlying, and loses if the underlying goes down. One interesting thing is that this strategy is nearly cash-neutral: in general, the price of the long put and the price of the short call are broadly equal, as they are equally far from the spot. Depending on the risk perception of the market, the prices might not be equal, with usually the put being more expensive.

Profit and risks

Being a strategy with almost no investment makes it possible to have massive leverage with this strategy. It can be essentially buying a call, or put, and financing it by selling the "opposite" instrument. As such, massive profits, or losses, can be accumulated.

One more interesting thing about the risk reversal which is particularly relevant for professional traders is the difference between the call and the put price. This difference depends primarily on the level of the spot: if the spot is closer to the strike of the call, the call will become more expensive, and if it is closer to the put, the put will become expensive. However, this exposure is easily hedged, leaving an exposure to dividend, interest rate and the something called volatility skew. This last bit is essentially the fact that there is a correlation between volatility and the level of the spot: if the market goes down, it tends to do so violently.

Collar

One very interesting strategy is the so-called collar. Imagine that an investor is long a stock, but is a bit less bullish for the near term. It is then possible to sell a call, and use the collected money to buy a put. Doing this, the risk is temporarily reduced; if the stock drops hard, the put compensates him, allowing him to sell the stock at the level of the strike. Of course, the downside is that has an opportunity loss if the stock goes up, because of the short call.

Conclusion

A risk reversal is an option strategy that consists of a short put and a long call, or of a long put and a short call. Here, the strike of the put is below the current spot by roughly the same amount the strike of the call is above it. It can be used to have a highly leveraged exposure to large movements in the underlying, but also to hedge the risk of a long stock positions by means of a so-called collar.

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