WHAT IS RISK REVERSAL STRATEGIES?

 

What is a Risk Reversal Strategy?

 

   A risk reversal strategy is a popular options trading strategy used by experienced traders and investors to hedge against potential losses or to speculate on the movement of a stock or other financial asset. Essentially, it involves combining two different options to form a position that provides a favorable risk-reward profile, often used to create a position with limited downside risk but unlimited upside potential.

 

The strategy typically consists of:

 

Selling a put option (short put):  This creates a liability or obligation to buy the underlying asset at a specific price (strike price) if the asset’s price drops below this level.

Buying a call option (long call):  This gives the holder the right to buy the underlying asset at a specific price if its price increases beyond the strike price.

   By selling a put option, the trader receives a premium (income), and this premium is often used to fund the purchase of the call option. This allows the trader to enter into a position with potentially zero net upfront cost or even a small credit.

 

How Does the Risk Reversal Strategy Work?

 

The risk reversal strategy is designed to benefit from a directional move in the price of an underlying asset. Here’s how it works in detail:

 

Selling the Put Option (Short Put):

 

By selling a put option, the trader obligates themselves to buy the asset at a predetermined strike price if the price falls below that level.

If the price of the asset stays above the strike price of the put, the trader will retain the premium collected from selling the put, and the option will expire worthless.

If the price falls below the strike price, the trader will be forced to buy the asset at the strike price, potentially incurring a loss.

 

Buying the Call Option (Long Call):

 

The trader purchases a call option, which gives them the right, but not the obligation, to buy the asset at a specific strike price.

If the price of the asset rises above the strike price of the call option, the trader will profit from the difference between the asset’s market price and the call’s strike price.

If the price does not rise above the strike price, the call option will expire worthless, and the trader will lose the premium paid for the option.

 

Example of a Risk Reversal Strategy

 

Let’s assume you’re bullish on a stock that is currently trading at $100 and expect its price to rise. You can use a risk reversal strategy as follows:

 

   Sell a put option with a Rs.95 strike price: You collect a premium of Rs.3. This means that if the stock’s price falls below Rs.95, you will be obligated to buy the stock at Rs.95. The premium collected partially covers the cost of the call option.

 

   Buy a call option with a Rs.105 strike price: You pay a premium of Rs.3 for this call option, which gives you the right to buy the stock at Rs.105 if its price rises above this level.

 

In this scenario:

 

If the stock price rises above Rs.105, the call option becomes profitable, allowing you to buy the stock at Rs.105 while it may be trading at a higher price.

If the stock price falls below Rs.95, you’ll have to buy the stock at Rs.95 (due to the short put), but you collected a premium that offsets some of your losses.

 

Key components of a risk reversal

 

Strike Prices:

 

   The choice of strike prices for both the put and call options is crucial. Typically, traders choose out-of-the-money (OTM) options for both positions. This means that the put option has a strike price lower than the current market price, and the call option has a strike price higher than the current market price.

 

Premiums:

 

   In many cases, the premium received from selling the put option can be used to fund the purchase of the call option. In an ideal risk reversal, the premiums are offset, resulting in a strategy that costs little or nothing to initiate. This is called a zero-cost risk reversal.

 

Expiration date:

 

The expiration date of both the put and call options must be the same. The time frame chosen depends on the trader's outlook on the asset's price movement.

 

Bullish vs. bearish risk reversals

 

While the risk reversal strategy is typically used in a bullish scenario, it can also be applied in a bearish one. The two main types of risk reversal strategies are:

 

Bullish risk reversal:

 

   The standard form of a risk reversal is bullish. In this case, the trader is selling a put option below the current price and buying a call option above the current price. This strategy is profitable if the price of the asset rises significantly, allowing the trader to capitalize on the call option.

 

Bearish risk reversal:

 

   In a bearish risk reversal, the trader would sell a call option and buy a put option. This strategy is used when the trader expects the price of the asset to decline. By selling the call option, the trader generates income to purchase the put option. If the price falls, the put option becomes profitable, while the call option expires worthless.

Benefits of using a risk reversal strategy

 

Low-cost/no-cost exposure:

 

   One of the most attractive features of a risk reversal strategy is the potential for low or zero initial cost. By offsetting the premium of the call with the sale of the put, traders can initiate the strategy with minimal upfront investment.

 

Leverage on directional moves:

 

   Risk reversals allow traders to profit from a significant directional move in the price of the underlying asset. Since the call option provides unlimited upside potential, this strategy is ideal for investors who expect a strong bullish move.

 

Limited downside (Compared to Stock Ownership):

 

When compared to outright stock ownership, a risk reversal strategy limits the downside risk. The loss is only incurred if the price of the asset drops below the strike price of the short put. While this still involves a risk, it is generally less than the risk of holding the asset outright if it falls significantly in value.

 

Flexible hedging:

 

Investors can use risk reversal strategies to hedge their existing positions. For example, a risk reversal can be used to hedge a long stock position by selling a call and buying a put.

Risks Associated with the Risk Reversal Strategy

Obligation to Buy or Sell the Asset:

 

When selling the put option in a bullish risk reversal, the trader is obligated to buy the underlying asset if its price falls below the strike price. This could result in significant losses if the asset's price drops substantially.

 

Limited gains (in Bearish Risk Reversal):

 

In a bearish risk reversal, the trader’s upside is limited by the premium collected from selling the call, while the downside is potentially significant if the asset’s price rises sharply.

 

Time decay:

 

   Both options in the risk reversal strategy are subject to time decay (theta), which can erode the value of the options as the expiration date approaches. If the asset's price does not move as expected, both the put and call options may expire worthless, resulting in a loss of the premiums paid.

 

When to Use a Risk Reversal Strategy?

 

Directional bias:  Use the risk reversal strategy when you have a strong conviction about the direction of an asset’s price. If you expect the price to rise, employ a bullish risk reversal, and if you expect a drop, use a bearish risk reversal.

 

Hedging:  It’s an effective tool for hedging existing stock positions. For instance, if you own stock and are concerned about a potential decline, a risk reversal can help offset some of the downside risk.

 

Conclusion

 

   A risk reversal strategy is a versatile options trading strategy that can be used for both speculation and hedging. By combining the sale of a put option with the purchase of a call option, traders can position themselves to profit from favorable moves in an asset’s price with a relatively low initial cost. However, like all options strategies, it carries risks and requires careful selection of strike prices and expiration dates to align with your market outlook.