Risk Reversal

What is Risk Reversal?

Risk Reversal is a kind of derivative strategy that locks both downside risk and upside potential of a stock by using derivative instruments. The main components of risk reversal strategy call and put options. They are designed to protect an open position from going against your favor. When you are buying a derivative instrument to protect your position, it comes with a cost that makes your position costly. This cost can be mitigated by short selling another derivative instrumentDerivative InstrumentDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more at the same time.

This strategy is also used in the FOREX market to gauge the movement of currency. There are several derivative strategies that are used in the financial world to either hedge or to maximize profit by minimizing loss, and so on.

How Does Risk Reversal Work?

Risk Reversal strategy consists of two options, that is call and put. Before understanding this strategy, it’s important to understand the concept of call and put in options.

In risk reversal options, the strategy says a person in holding stock. Then he must have had a fear of the stock price going down. So as he is long on stock so to protect himself, he will have to short a risk reversal.

A risk reversal strategy is also used in the Forex market to gauge the movement of a particular currency. It is the difference of implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.read more of call and put option on the currency. Implied volatility indirectly related to the demand for call and put option. If the reversal is positive, it means the demand for a call option is more, which states that everyone wants to buy that particular currency.

risk reversal

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Example of Risk Reversal Option Strategy

Mr. X is holding shares of ABC Company at $10. He is afraid of the share price going down. Suggest a cost-effective strategy.

Solution:

Mr. X can buy a put option @ $9, which will cost him a premium say @1. Now to minimize the cost, Mr. X can sell a call option, say at $13. The premium for a call option is said $0.5. So Mr. X spent $1 and earned back $0.5. So-net he spent $0.5.

Earlier, Mr. X would have had an unlimited profit when the stock price would have gone up, but now he has foregone the upside potential as he will have to sell the stock at $13. He has also eliminated the risk of the stock price going down as he will be able to sell the stock at $9, no matter how far the stock price goes down.

So Risk Reversal Strategy acts as a collar, where both loss and gain are limited.

Reasons for Trading Risk Reversal

  • It helps to protect an investor from the Short/Long Position of stock and also reduces the cost of the protection.
  • It helps to gauge the direction of the movement of a particular currency.

How to Use?

Risk Reversal acts as a collar for a stock. If you have either a long or short position in a stock and you are afraid that the stock may move opposite to your prediction, and you may incur a loss, then to safeguard yourself, you may either buy a call or put option. Option buying is expensive, so to minimize the cost, you will have to write the opposite options.

Advantages

  • Loss is limited, so it can be used for those who don’t want to take the high risk.
  • In the forex market, it helps to predict the currency movement.

Disadvantages

  • The strategy is costly.
  • If the stock price remains stagnant, then the continuation of this strategy will result in losses.

Conclusion

Risk Reversal is a derivative hedging strategy where a person is predicting a movement in stock but still wants to safeguard himself from the opposite movement. Continuation of this strategy will be costly if the stock price doesn’t move as predicted. This strategy is really helpful for individuals who don’t want to take much risk.

This has been a guide to what is risk reversal. Here we discuss reasons for trading risk reversal along with its uses, investment strategy, and example. You can learn more about portfolio management from the following articles –