Introduction
A
risk reversal is a combination of
options. As such, a risk reversal is
an example of an
option strategy. In this writeup, we will see how a
risk
reversal is built, what the potential
profit and
risks are. This writeup assumes
the reader is familiar with what an
option is.
How to build a risk reversal
A risk reversal consists of two options with the same time to expiry on the same
underlying. The first option is a short out the money
call, and the second is a
long out the money
put. This means that the
strike of the put is lower than the
call. Normally, the strikes of the risk reversal are both equally far from the
current price of the
underlying. This strategy has the following payoff at
expiration
- Below the strike of the put: The call is worthless, and the long in the money put
has a value of 1 for each 1 the underlying is below the the strike.
- Above the strike of the put, but below the strike of the call: All options expire
worthless.
- Above the strike of the call: The put is worthless, but the short call is not. As
such, the value is -1 for each 1 the underlying is above the strike.
A risk reversal in this form is a
bearish strategy. It is, of course, equally
possible to set up the opposite trade if one is
bullish; by being long the
call and short the
put, one profits from an increase in the underlying, and loses
if the underlying goes down. One interesting thing is that this strategy is nearly
cash-neutral: in general, the price of the long put and the price of the short call
are broadly equal, as they are equally far from the
spot. Depending on the
risk
perception of the market, the prices might not be equal, with usually the put being
more expensive.
Profit and risks
Being a
strategy with almost no investment makes it possible to have massive
leverage with this strategy. It can be essentially buying a
call, or
put, and
financing it by selling the "opposite" instrument. As such, massive profits, or
losses, can be accumulated.
One more interesting thing about the
risk reversal which is particularly relevant
for
professional traders is the difference between the
call and the
put price.
This difference depends primarily on the level of the
spot: if the
spot is closer
to the strike of the
call, the call will become more expensive, and if it is closer
to the
put, the put will become expensive. However, this exposure is easily
hedged, leaving an exposure to
dividend,
interest rate and the something
called
volatility skew. This last bit is essentially the fact that there is a
correlation between volatility and the level of the spot: if the market goes down,
it tends to do so violently.
One very interesting strategy is the so-called
collar. Imagine that an investor is
long a
stock, but is a bit less
bullish for the near term. It is then
possible to sell a
call, and use the collected
money to buy a
put. Doing this,
the
risk is temporarily reduced; if the stock drops hard, the
put compensates
him, allowing him to
sell the
stock at the level of the strike. Of course, the
downside is that has an
opportunity loss if the stock goes up, because of the short
call.
Conclusion
A
risk reversal is an
option strategy that consists of a
short put and a
long
call, or of a
long put and a
short call. Here, the strike of the put is below the
current
spot by roughly the same amount the strike of the call is above it. It can
be used to have a highly leveraged exposure to large movements in the
underlying,
but also to
hedge the risk of a
long stock positions by means of a so-called
collar.