Risk Reversal

Article bySourav Sinha
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Risk Reversal?

Risk Reversal is a kind of derivative strategy that locks both the downside risk and upside potential of a stock by using derivative instruments. The main components of the risk reversal strategy are 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.

risk reversal

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Risk Reversal (wallstreetmojo.com)

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.

Key Takeaways

  • Risk reversal is an options trading strategy that involves simultaneously buying a call option and selling a put option on the same underlying asset with the same expiration date.
  • Risk reversal strategies express a directional bias on the underlying asset. A bullish risk reversal involves buying a call option and selling a put option, indicating an expectation of upward price movement. Conversely, a bearish risk reversal consists in buying a set option and selling a call option, reflecting a belief in downward price movement.
  • Risk reversal strategies offer limited risk and potential reward. By selling one option to offset the cost of buying the other, traders can reduce the upfront cost of the plan.
  • Changes can influence risk reversal strategies in implied volatility. An increase in volatility generally benefits risk reversals, as it raises the value of the options held, potentially increasing profits.

How Does Risk Reversal Work?

Risk Reversal is a derivative hedging strategy where a person is predicting a movement in stock but still wants to safeguard themselves 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.

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.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

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

Risk reversal 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 is indirectly related to the demand for the 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.

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Risk Reversal (wallstreetmojo.com)

Example

Let us understand the concept of risk reversal option with the help of an of example. This example will help us understand the intricacies of the concept in-depth.

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.

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

Reasons

Let us understand the reasons why investors and traders adopt the risk reversal strategy to earn premiums and hedge risks through the points below.

  • 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?

Now that we understand the fundamentals and the basic related factors of the concept, it is vital for us to understand how to use it to make gains or mitigate risks in every situation in the market.

  • Risk reversal options act 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.
  • When the market is in a bull run, quality stocks generally show the impact first. Therefore, there is a diminished risk of holding these stocks through the short put leg of the bullish reversal strategy.
  • Moreover, when a market is in a bull run and a highly reputed share, say a blue chip stock experiences a sharp decline in its market value, a risk reversal strategy might give significant returns when the stock and the market consolidate.

Advantages

Let us understand the advantages of adopting the risk reversal strategy through the points below.

  • 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.
  • These strategies can be incorporated with little or sometimes with no additional costs involved.
  • Their usability in the market is wide. It is applicable in various scenarios of the market.
  • Despite the fact that it is still associated with a little risk, the potential to make better gains is increased.

Disadvantages

Despite the various advantages mentioned above, there are a few factors from the other end of the spectrum that prove to be a hassle for investors and traders alike. Let us understand the disadvantages of the risk reversal strategy through the discussion below.

  • The strategy is costly. It might sound contradictory to the statement made above. However, it is costly in terms of the margin requirements and not for adopting the strategy per se.
  • If the stock price remains stagnant, then the continuation of this strategy will result in losses.
  • While it limits the losses in most situations, scenarios like a short call leg during a bearish risk reversal can be extremely risky; sometimes too risky for an average investor.

Frequently Asked Questions (FAQs)

How does risk reversal differ from other options strategies?

Risk reversal differs from other options strategies, involving buying and selling options on the same underlying asset. This strategy helps manage the cost of entering a position and provides a limited risk and reward profile.

What is the purpose of a risk reversal strategy?

A risk reversal strategy aims to express a directional view of the underlying asset while limiting downside risk. It allows traders to participate in potential price movements while offsetting some costs through simultaneous buying and selling options.

What factors should be considered when implementing a risk reversal strategy?

When implementing a risk reversal strategy, factors such as the strike prices of the options, expiration dates, implied volatility, and the underlying asset’s price movement expectations should be considered. These factors can impact the strategy’s cost, risk exposure, and potential profitability.

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