A risk reversal is an option strategy constructed as the combination of a short out-of-the-money (OTM) put and a long OTM call. Although the structure is fairly basic, it’s more commonly employed by institutional rather than retail investors.
Rationale Behind Using Risk Reversals
As is the case for most options and option strategies, risk reversals are mainly used for two reasons: speculation and hedging.
A derivatives trader would typically buy a risk reversal, by shorting the put and going long the call, to express a speculative, bullish directional view on the underlying. Similarly, selling a risk reversal, shorting the call and going long the put, establishes a speculative short position.
For hedging purposes, the risk of an existing long position on the underlying could be efficiently managed with a short risk reversal, and vice versa.
Similarities and Differences between Risk Reversals and Vertical Spreads
The composition of a risk reversal bears some similarities to that of a vertical spread, in that it comprises of an equal amount of long and short options, which all have the same maturity and different strikes.
Contrary to vertical spreads, however, risk reversals don’t involve options of the same type, i.e. a set of either calls or puts. This results in a fundamental difference in the purpose and behavior between the two option strategies, in particular with respect to their payout profiles.
Both building blocks of a risk reversal exhibit the same directional properties; bullish in the case of a short put and a long call, or bearish for a long put and a short call. Consequently, contrary to a vertical spread whereby the directional view is capped as the second option cancels the effect of the first, the directional properties of a risk reversal strategy remain unchanged throughout the structure. This can be seen in the payout profiles for a bullish and a bearish risk reversal below.
Benefits and Risks of a Risk Reversal Strategy
Like every option strategy, a risk reversal comes with its own set of benefits and risks. The main advantage of the strategy to the investor is that it allows for the creation of a directional view on the underlying with very little, if any at all, upfront cost. Moreover, if there’s some flexibility on the part of the investor for the option strikes or if the volatility skew allows it, the structure could even be initiated for a net credit.
On the flipside, the main risk for an investor entering a risk reversal is the evolution of the margin requirements, should the assessment of the directional view prove incorrect. And finally, as can be seen from the two charts above, both the risk as well as the profit potential of a risk reversal are unlimited.
In summary, risk reversals are fairly elementary option strategies for the experienced trader. They can be used to efficiently express a directional view on the underlying without limiting the potential profit, but they also come with potentially unlimited risk.