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.
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. 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.
Table of contents
- 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.
- The call is the right to buy something and put the right to sell something. So, if you are buying CALL, then it gives you the right but not the obligation to buy a stock. Similarly, if you buy the PUT optionPUT OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated., then it gives you the right to sell a stock but not an obligation that you will have to sell it at any cost.
- So as both the options give you the right and not the obligation, they come with a cost. You need to pay a premium to buy this option. So, if you buy a stock and buy put on that stock, then if stock prices go down, then also you can sell the stock at the agreed price.
- Similarly, if you sell an option, then it becomes your liability to do it. Say you have sold a call option, then it becomes your liability to sell the stock at an agreed price, even if the stock price goes way up, you will have to sell it at a lower agreed price.
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.
- To protect thelselves from the stock price going down, they can buy a put option. This put option will help them in case the stock price goes down. To buy a put option, they will have to pay a premium. Now to minimize the cost of the premium, they will be selling a call option, which will help they to earn some premium, and thus in the net, the cost of the put option is reduced.
- Similarly, if a person is short on a stock, then they will have to long a risk reversal. Hence, they will purchase a call option and write a put optionWrite A Put OptionWriting put options refer to the opportunity availed by an investor to own and sell an underlying asset at an exceptional pre-determined price on a future date. The owner has the right but not the obligation to sell off the underlying asset. on the underlying stock. The risk of a short position is that if the stock price rises. So, the call option will protect in that case. The price of the call option is reduced with the premium earned from selling a put option.
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. 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.
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.
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.
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.
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.
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)
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.
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.
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 –