A risk reversal is an options strategy that is used to protect a long or short position on an underlying security.
The risk reversal strategy is appealing to experienced investors because it offers the potential to hedge against unfavorable price swings with a very little cost. This article will cover the basics of the risk reversal strategy and how an investor can use it in their investment playbook.
The risk reversal strategy is the simultaneous sale of an “out-of-the-money” call or put option along with the purchase of the opposite “out-of-the-money” option. In simpler terms, an investor sells an option and uses the funds received from that premium to pay for the other option.
The risk reversal strategy can be executed in two ways:
1.
The simultaneous sale of an “out-of-the-money” put option with the purchase of an “out-of-the-money” call option with the same expiration date.
This strategy is used if an investor wants to hedge his position while shorting an underlying asset. If the market price of the underlying stock rises, then the call option will become more valuable and offset the loss on the short position. If the market price of the stock declines sharply, then the investor will profit from the short position, but only down to the strike price of the written put option.
Let’s look at an example of this scenario.
Assume Stock ABC is trading at $40. An investor is shorting 100 shares of ABC and wishes to hedge his position without paying any extra money. A call option with a $42 strike price that expires in a month is quoted at $1. A put option with a $38 strike price that expires in one month is also quoted at $1. Assume the investor sales the put option and uses the premium paid to him to purchase the call option. Now, he has a hedge against the stock rising above $42 because of the call option. If the stock price falls, then he will profit from his short position, but only until the put option strike price of $38.
2.
The simultaneous sale of an “out-of-the-money” call option with the purchase of an “out-of-the-money” put option with the same expiration date.
This strategy is used if an investor wants to hedge his position while long on an underlying security. If the market price of the underlying stock declines sharply, then the put option will increase in value and offset the loss on the underlying stock. If the market price of the stock rises, then the investor will profit from the increase in the underlying, but only up to the strike price of the written call option.
Let’s look at an example of this scenario as well.
Assume Stock ABC is trading at $40. An investor owns 100 shares of ABC and wishes to hedge his position without paying additional money. Just like the previous example, a call option with a $42 strike price that expires in a month is quoted at $1. A put option with a $38 strike price that expires in one month is also quoted at $1. Assume this time, the investor sales the call option and uses the premium paid to him to purchase the put option. Now, he has a hedge against the stock falling below $38 because of the put option. If the stock rises, then he will profit from the increase in stock price, but only until the call option strike price of $42.
The risk reversal strategy is a low-cost way of hedging a long or short position on an underlying security. This is a great strategy an investor can use to better protect himself against risk.
