Risk reversal

What Is Risk Reversal?

A risk reversal is a specific type of options strategy that involves simultaneously buying one option and selling another, typically an out-of-the-money (OTM) call option and an OTM put option on the same underlying asset with the same expiration date. This strategy falls under the broader category of options strategies. The primary goal of a risk reversal is to express a directional view on an underlying asset's price movement while potentially reducing the net cost of establishing the position or even generating a credit. It is frequently used to replicate a synthetic position in the underlying asset or to enhance returns on an existing stock holding by monetizing implied volatility skew.

History and Origin

The concept of using options for speculation and hedging dates back centuries, with early forms of option contracts appearing on European exchanges as early as the 16th century in Antwerp and the 17th century in Amsterdam.⁹ While the specific term "risk reversal" as a standardized options strategy is a more modern development, its underlying components, the buying and selling of calls and puts, are rooted in the fundamental principles of options mechanics that have evolved over time. The formalization and widespread adoption of complex multi-leg options strategies, including the risk reversal, significantly accelerated with the establishment of organized options exchanges like the Chicago Board Options Exchange (CBOE) in 1973, which introduced standardized strike price and expiration dates.⁸ The strategy gained prominence as traders sought to capitalize on or hedge against market views, often utilizing the phenomenon of volatility skew, where OTM puts tend to have higher implied volatility than OTM calls.

Key Takeaways

A risk reversal is an options strategy combining a long call and a short put (or vice versa) with the same expiration date.
It is often used to express a strong directional bias on an underlying asset.
The strategy can be established for a net credit, a net debit, or approximately zero cost, depending on the strike prices and market implied volatility.
Risk reversals can replicate synthetic long or short positions in an underlying asset.
The strategy is sensitive to changes in implied volatility and price movements of the underlying asset.

Formula and Calculation

A risk reversal strategy involves the simultaneous purchase of one out-of-the-money (OTM) call option and the sale of one OTM put option, or vice versa, typically on the same underlying equity and with the same expiration month. The "formula" primarily relates to the net premium received or paid when initiating the position.

Net Premium = Premium Received from Short Put - Premium Paid for Long Call

Net Premium = Premium Received from Short Call - Premium Paid for Long Put

Where:

Premium Received from Short Put = The price received for selling the out-of-the-money put option.
Premium Paid for Long Call = The price paid for buying the out-of-the-money call option.
Premium Received from Short Call = The price received for selling the out-of-the-money call option.
Premium Paid for Long Put = The price paid for buying the out-of-the-money put option.

The strike prices of the options are crucial to defining the strategy's risk/reward profile. For a bullish risk reversal, an investor would sell an OTM put with a lower strike price and buy an OTM call with a higher strike price.

Interpreting the Risk Reversal

Interpreting a risk reversal involves understanding its implied directional bias and the impact of the net premium.

Bullish Risk Reversal (Long Call / Short Put): This structure indicates a bullish sentiment, expecting the underlying asset's price to increase. If established for a net credit (premium received from the put exceeds premium paid for the call), it implies that the market perceives a higher risk of the downside (reflected in the put's premium) than the upside. The investor is essentially being paid to take on the downside risk below the put strike, while gaining upside participation above the call strike. The position behaves similarly to a long stock position for movements between the two strike prices.
Bearish Risk Reversal (Short Call / Long Put): Conversely, this structure reflects a bearish outlook, anticipating a decline in the underlying asset's price. If established for a net credit (premium received from the call exceeds premium paid for the put), it suggests that the market sees more upside risk (reflected in the call's premium). The investor receives payment for taking on upside risk above the call strike, while benefiting from a fall in price below the put strike. This position acts like a short stock position within the strike range.

The relationship between the implied volatilities of the put and call options in a risk reversal is often referred to as delta skew or volatility skew. A common observation in equity markets is that out-of-the-money put options typically have higher implied volatility than equidistant out-of-the-money call options, a phenomenon known as "skew."⁷ A risk reversal effectively expresses a view on this volatility skew, profiting if the skew flattens or reverses in the desired direction.

Hypothetical Example

Consider an investor who is bullish on Company XYZ, whose shares currently trade at $100. The investor believes the stock will rise but wants to finance part of the upside potential or gain exposure without buying shares outright.

They implement a bullish risk reversal with options expiring in two months:

Sell 1 XYZ $95 Put Option: Receives a premium of $3.00. This put is OTM since the current stock price is $100.
Buy 1 XYZ $105 Call Option: Pays a premium of $2.50. This call is also OTM.

Calculation:
Net Premium Received = $3.00 (from short put) - $2.50 (for long call) = $0.50 (credit)

Scenario 1: XYZ closes at $110 at expiration.

The $95 put expires worthless (XYZ is above $95).
The $105 call expires in-the-money, with an intrinsic value of $110 - $105 = $5.00.
Total profit = Call profit + Net premium received = $5.00 + $0.50 = $5.50 per share.

Scenario 2: XYZ closes at $98 at expiration.

The $95 put expires worthless.
The $105 call expires worthless.
Total profit = Net premium received = $0.50 per share. The investor keeps the credit.

Scenario 3: XYZ closes at $90 at expiration.

The $95 put expires in-the-money, with an intrinsic value of $95 - $90 = $5.00. The investor is obligated to buy shares at $95.
The $105 call expires worthless.
Total loss = Put loss - Net premium received = -$5.00 + $0.50 = -$4.50 per share. The investor effectively buys the stock at $95 but loses $4.50 (or $450 for 100 shares) on the option premiums.

This example illustrates how the risk reversal allows for participation in upside movements (Scenario 1) or generates income if the stock stays within the strikes (Scenario 2), but exposes the investor to significant downside risk below the short put strike (Scenario 3).

Practical Applications

Risk reversals are widely used in options trading by various market participants for several strategic purposes:

Expressing Directional Views: Traders use risk reversals to express a strong bullish or bearish outlook on an underlying asset, particularly when they anticipate a significant move. A bullish risk reversal, by selling a put and buying a call, essentially replicates a long position in the underlying asset, while a bearish risk reversal (selling a call and buying a put) replicates a short position.⁶
Hedging and Portfolio Management: While primarily speculative, risk reversals can be components of larger hedging strategies. For instance, a corporation or institutional investor might use a risk reversal to synthetically hedge a foreign currency exposure, adjusting their exposure to favorable or unfavorable rate movements.⁵
Monetizing Volatility Skew: Professional traders often employ risk reversals to take advantage of or hedge against the implied volatility skew in the market. If they believe OTM puts are overvalued relative to OTM calls (a common scenario), they might initiate a bullish risk reversal to sell that "expensive" put volatility and buy "cheaper" call volatility, potentially for a net credit. This tactic is especially prevalent in index options and currency markets.
Synthetic Stock Positions: A risk reversal can be structured to create a synthetic position in the underlying asset, offering a way to gain exposure without directly buying or shorting the shares. This can sometimes be more capital-efficient than trading the underlying asset directly.⁴
Market Sentiment Indicator: The premiums for out-of-the-money options often reflect market sentiment and perceived risks. Analysis of the pricing of risk reversals (the difference in implied volatility between OTM calls and puts) can provide insights into whether market participants are generally more concerned about downside risks (pushing put premiums higher) or anticipating upside breakouts (increasing call premiums). For instance, Cboe Global Markets provides real-time and historical data on options market activity, which can be used to observe these trends.³

Limitations and Criticisms

Despite their versatility, risk reversals carry inherent limitations and criticisms that investors should consider:

Unlimited Risk Potential: While the name "risk reversal" might suggest a controlled risk profile, a naked short put option (in a bullish risk reversal) carries substantial downside risk, as the underlying asset can theoretically fall to zero. Similarly, a naked short call option (in a bearish risk reversal) exposes the investor to unlimited upside risk if the underlying asset's price rises indefinitely.² This highlights that the "reversal" refers to the directional bias, not necessarily a reversal of risk itself.
Margin Requirements: Due to the unlimited risk potential of the short option leg, initiating a risk reversal often requires significant margin. This means that while the net premium might be small or even a credit, the capital held by the broker as collateral can be substantial.
Complexity: Risk reversals are multi-leg strategies that require a solid understanding of option pricing, implied volatility, and how different factors (like time decay and price movements) affect each leg. This complexity makes them less suitable for novice traders.
Liquidity Concerns: While major indices and highly traded stocks generally have liquid options markets, less common underlying assets or very far out-of-the-money strike price can suffer from low liquidity and wide bid-ask spreads. This can make it difficult to enter or exit the risk reversal strategy at favorable prices.
Time Decay (Theta): The impact of time decay, or theta, can be nuanced. While the net theta might be positive or negative depending on the specific strikes and volatilities, the value of both options erodes as the expiration date approaches, which can work against the position if the expected price movement does not occur.
Regulatory Scrutiny: The Securities and Exchange Commission (SEC) emphasizes that options trading involves significant risks and is not suitable for all investors. Investors are advised to thoroughly understand these risks before engaging in options strategies.¹

Risk Reversal vs. Collar Strategy

While both are multi-leg option strategies involving a call option and a put option, the core difference between a risk reversal and a collar strategy lies in their underlying purpose and the investor's exposure to the underlying asset.

A risk reversal is typically used to express a directional view on an asset without necessarily owning (or shorting) the asset itself, or to capitalize on implied volatility skew. A bullish risk reversal involves selling an OTM put option and buying an OTM call option. This creates a payoff similar to a long stock position but without the upfront capital outlay of buying shares. Its risk is unlimited on the downside due to the short put.

In contrast, a collar strategy is a protective strategy used by investors who already own the underlying stock. It involves owning shares, buying an OTM put option (for downside protection), and simultaneously selling an OTM call option (to generate income and offset the cost of the put). The collar limits both the potential downside (due to the long put) and the potential upside (due to the short call) of the stock position. Its primary aim is to protect an existing long position, not to express a new directional view or gain synthetic exposure.

FAQs

What is the primary purpose of a risk reversal strategy?

The primary purpose of a risk reversal is to express a strong directional view on an underlying asset's price movement. For example, a bullish risk reversal (selling a put option, buying a call option) suggests an expectation that the asset price will increase.

Can a risk reversal be established for a credit?

Yes, a risk reversal can be established for a net credit, a net debit, or approximately zero cost, depending on the chosen strike price and the prevailing implied volatility of the individual option legs. If the premium received from the short option is greater than the premium paid for the long option, the strategy yields a net credit.

Is a risk reversal a high-risk strategy?

Yes, a risk reversal is generally considered a high-risk strategy. This is because one leg of the strategy involves selling an uncovered option (either a naked put option or a naked call option), which has the potential for unlimited losses if the market moves significantly against the position.

How does volatility skew affect a risk reversal?

Volatility skew, which refers to the difference in implied volatility across different strike prices, significantly impacts the pricing of a risk reversal. A common equity skew sees OTM puts having higher implied volatility than OTM calls. A bullish risk reversal benefits if the implied volatility of the short put decreases relative to the long call, or if the skew flattens.