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.
- 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 option, 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 right and not the obligation, so 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 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.
- To protect himself from the stock price going down, he can buy a put option. This put option will help him in case the stock price goes down. To buy a put option, he will have to pay a premium. Now to minimize the cost of the premium, he will be selling a call option, which will help him to earn some premium, and thus in net, the cost of the put option is reduced.
- Similarly, if a person is short on a stock, then he will have to long a risk reversal. So he 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.read more 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 premium earned from selling a put option.
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 volatility 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.
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Source: Risk Reversal (wallstreetmojo.com)
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.
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