The potential for a big payoff for very little premium is the inherent attraction of a risk reversal strategy. Risk reversal strategies are widely used in the forex and commodities options markets. But, they tend to be used primarily by institutional traders and seldom by 澳洲幸运5官方开奖结果体彩网:retail investors when it comes to equity options. Risk reversal strategies may seem a little daunting tꦕo the option neophyte, but they can be a very useful option for experienced investors who are familiar with basic puts and calls.

What Is Risk Reversal?

The most basic risk reversal strategy consists of selling (or writing) a 澳洲幸运5官方开奖结果体彩网:put option that is 澳洲幸运5官方开奖结果体彩网:out-of-the-money (OTM) and simultaneously buying an OTM call. This is a combination of a 澳洲幸运5官方开奖结果体彩网:short put position and a long call position.

Since writing the put results in the trader receiving a certain amount of premium, this 澳洲幸运5官方开奖结果体彩网:premium income can be used to buy the call. If the cost of buying the call is greater than the premium received for writing the put, the strategy would 🐷involve a net debit.

But if the premium received from writing the put is greater than the cost of the call, the strategy generates a net credit. If the put premium received equals the outlay for the call, this would be a costless or zero-cost trade. Of course, 澳洲幸运5官方开奖结果体彩网:commissions have to be considered as well, but𝓀 in the examples that follow, we ignore them to keep things simple.

The reason why it's called risk reversal is that it reverses the volatility skew risk a trader usually confronts. Put simply, OTM puts typically have higher implied volatilities (and are thus more expensive) than OTM calls, because of the greater demand for protective puts to hedge long stock positions. Since a risk reversal strategy generally entails selling options with a higher 澳洲幸运5官方开奖结果体彩网:implied volatility and buying options 🧸with a lower impl🉐ied volatility, this skew risk is reversed.

Applications of Risk Reversal

Risk reversals can be used for 澳洲幸运5官方开奖结果体彩网:speculation or hedging. When used for speculation, a risk reversal strategy can simulate a synthetic long or 澳洲幸运5官方开奖结果体彩网:short position. When used for hedging, a risk reversal strategy is used to hedge the r♐isk of an💙 existing long or short position.

The two basic variations of a risk reversal strategy used for speculation and hedging are noted in the fo🔜llowing tables.

When to Use Risk Reversals

There are some specific instances when risk reversal strategies can be optimally used. We've noted some of the most common times below.

Favor a Stock, Need Leverage

Risk reversal strategies are useful when you like a stock but require soꦡme leverage. If you like a stock, writing an OTM put on it is a no-brainer strategy if:

1. You do not have the funds to buy it outright, or
2. The stock looks a little pricey and is beyond your buying range

In this case, writing an OTM put will earn you some premium income, but yo🌟u can double down on your bullish view by buying an OTM call with part of the put-♑write proceeds.

In a Bull Market

Good quality stocks can surge in the early stages of a bull market. There is a diminished risk of being assigned on the sꦑhort put leg of bullish risk reversal strategies during such times, while the OTM calls can have dramatic price gains if th🅺e surge of the underlying stock.

Before Major Events

These major events include spinoffs and others like an imminent stock split. Investor enthusiasm in the days before a spinoff or a 澳洲幸运5官方开奖结果体彩网:stock split typically provides solid downside support and results in appreciable price gains, the iꦚdeal environment for a risk reve⛄rsal strategy.

Blue Chip Drops in Bull Markets

Risk reversal strategies come in handy when a 澳洲幸运5官方开奖结果体彩网:blue chip company's stock abruptly plꦛunges, es𝓡pecially during strong bull markets.

During strong bull markets, a blue chip that temporarily falls out of favor because of an earnings miss or some other unfavorable event is unlikely to stay 澳洲幸运5官方开奖结果体彩网:in the penalty box for very long.

Implementing a risk reversal strategy with medium-term expiration (say six months) may pay off handsomely if the stock rebounds during this period.

Advantages and Disadvantages of Risk Reversals

Advantages

Risk reversal strategies come at a low cost. As such, theyও can be implemented with little to no expense by the trader.

There is also a favorable 澳洲幸运5官方开奖结果体彩网:risk-reward profile associated with risk reversal strategies. While not without risks, these strategies can be designed to have unli♔mited potential profit and lower r꧋isk.

Traders can use risk reversal strategies in a wide range of situations. This means that reversals aren't just for complex or specific trading strategies. Rather, you can use reversals in any number of trading scenarios.

Disadvantages

• Margin requirements can be onerous. Margin requirements for the 澳洲幸运5官方开奖结果体彩网:short leg of a risk reversal can be quite substantial.
• There is a substantial risk on the short leg. The risks on the short put leg of a bullish risk reversal, and the 澳洲幸运5官方开奖结果体彩网:short call leg of a bearish risk reversal, are substantial and may exceed the 澳洲幸运5官方开奖结果体彩网:risk tolerance of the average investor.
• Doubling down. 澳洲幸运5官方开奖结果体彩网:Speculative risk reversals amount to doubling down on a bullish or bearish position, which is risky if the rationale for the trade proves to be incorrect.

Examples of Risk Reversal

Let’s use Microsoft (MSFT) to illustrate the de🐟sign of a risk reversal strategy for speculation,👍 as well as for hedging a long position.

Assume that Microsoft closes at $41.11 in June. At that point, the MSFT October $42 calls were last quoted at $1.27 / $1.32, with an implied volatility of 18.5%. The MSFT October ও$40 puts were quoted at $1.41 / $1.46, with an implied volatility of 18.8%.

Speculative Trade

This type of trade involves a synthetic long position or bullish risk reversal. Now let's take a look at an example using the information about Microsoft noted above.

• Write 5x the MSFT October $40 puts at $1.41, and buy 5x the MSFT October $42 calls at $1.32.
• Net credit (excluding commissions) = $0.09 x 5 spreads = $0.45.

Note these points:

• With MSFT last traded at $41.11, the $42 calls are 89 cents out-of-the-money, while the $40 puts are $1.11 OTM.
• The 澳洲幸运5官方开奖结果体彩网:bid-ask spread has to be considered in all instances. When 澳洲幸运5官方开奖结果体彩网:writing an option (put or call), the option writer will receive the 澳洲幸运5官方开奖结果体彩网:bid price, but when buying an option, the buyer has to shell out the ask price.
• Different option expirations and strike prices can also be used. For instance, the trader can go with the June puts and calls rather than the October options if they think that a big move in the stock is likely in the 1.5 weeks left for option expiry. But while the June $42 calls are much cheaper than the October $42 calls ($0.11 vs. $1.32), the premium received for writing the June $40 puts is also much lower than the premium for the October $40 puts ($0.10 vs. $1.41).

What is the risk-reward payoff for this strategy? Very shortly before option expiration on Oct. 18, there are three potential scenarios concern🎃ing the strike pr♊ices:

1. MSFT is trading above $42: This is the best possible scenario since this trade is equivalent to a synthetic long position. In this case, the $40-strike puts will expire worthless, while the $42 calls will have a positive value (equal to the current stock price less $42). Thus if MSFT has surged to $45 by Oct. 18, the $42 calls will be worth at least $3. So the total profit would be $1,500 ($3 x 100 x 5 call contracts).
2. MSFT is trading between $40 and $42: In this case, the $40 put and $42 call will both be on track to expire worthless. This will hardly make a dent in the trader’s pocketbook, since a marginal credit of nine cents was received at trade initiation.
3. MSFT is trading below $40: In this case, the $42 call expires worthless, but since the trader has a short position in the $40 put, the strategy will incur a loss equal to the difference between $40 and the current stock price. So if MSFT has declined to $35 by Oct. 18, the loss on the trade is equal to $5 per share, or a total loss of $2,500 ($5 x 100 x 5 put contracts).

Hedging Transaction

Assume the investor already owns 500 MSFT shares and wants to hedge 澳洲幸运5官方开奖结果体彩网:downside risk at a minimal cost. (This is a combinat🍨ion of a covered call + protective put).

• Write 5x the MSFT October $42 calls at $1.27, and buy 5x the MSFT October $40 puts at $1.46.
• Net debit (excluding commissions) = $0.19 x 5 spreads = $0.95.

What is the risk-reward payoff for this strategy? Very shortly before op📖tion expiration on Oct. 18, there are three potential scenarios concerning the strike prices:

1. MSFT is trading above $42: In this case, the stock will be 澳洲幸运5官方开奖结果体彩网:called away at the call 澳洲幸运5官方开奖结果体彩网:strike price of $42.
2. MSFT is trading between $40 and $42: In this scenario, the $40 put and $42 call will both be on track to expire worthless. The only loss the investor incurs is the cost of $95 on the hedge transaction ($0.19 x 100 x 5 contracts).
3. MSFT is trading below $40: Here, the $42 call will expire worthless, but the $40 put position would be profitable, offsetting the loss on the long stock position.

Why would an investor use such a strategy? Because of its effectiveness in hedging a long position that the investor wants to retain, at minimal or zero cost. In this specific example, the investor may have the view that MSFT has little upside potential but significant downside risk in the 澳洲幸运5官方开奖结果体彩网:near term. As a result, they may be willing to sacrifice any upside beyond $42, in return for obtaining 澳洲幸运5官方开奖结果体彩网:downside protection below a stock price of $40.

The Bottom Line

Options can be complicated investments, so they're not designed for the novice investor. That's because there are so many intricacies involved. You need to have a deep understanding of how they work to reap the benefits associated with them. Once you get the hang of them, the highly favorable risk-reward payoff and low cost of risk reversal strategies enable them to be used effectively in a wide range of trading scenarios.