Risk Reversal Option Strategy
Have you always put off trading option because of the risk involved? What if we can reverse the risk and give you the opportunity to trade options without assuming all the risk involved. This is possible by using an option trading strategy known as the risk reversal option trading strategy.
When you take a good look at other option strategies, you will notice one thing they all have in common; most of them use the leverage of options to limit risk, so that they can increase the chances of making profit and ultimately get returns that are bigger percentage-wise than just owning stock. However, there isn’t always 100% certainty of making a profit, in fact risk can still be 100% of the investment and most a times returns can still be lower than expected especially when the timing of move does not agree with the expiration date.
Risk reversal strategy is one very good option trading strategy that combines all the above attributes. Risk reversal is also known as “combo strategy” in some market because of its ability to combine all these basic attributes mentioned above.
What is Risk Reversal?
Risk reversal strategy is an option trading strategy that mostly involves selling an out-of-money put option, and in the same hands purchasing an out-of-the-money call option. Risk reversal involves the combination of a short put position and a long call position. Selling the put option will lead to the trader making a specific amount of premium, hence he now use the premium income to buy the call. In a situation where a trader purchased the call at price higher than the premium he received for selling the out-of-the-money put, this strategy will result in a net debit. In the other hand, when the premium the trader receive for selling the out-of-the-money put is greater than the price of the call, our risk reversal strategy will generate a net credit. In a rare situation where these two are equal i.e. put premium the trader received is equal to the cost of buying call, our strategy would lead to a cost less or zero-cost trade.
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Risk reversal strategy helps the trader to reverse the volatility skew that the option trader usually faces; this is the reason why this strategy is called Risk reversal”.
Here is an example of how risk reversal strategy works
Lets assume that we are trading Facebook option for speculation as well as for hedging a long position.
Our Facebook option closed at $31.11 on August 20, 2015. However, the Facebook December $32 calls were last quoted at the price $1.27/$1.32 with estimated volatility of 16.5%. The Facebook December $30 puts stands at $2.41/$2.46, with an estimated volatility of 16.8%
If our trader sells the Facebook December $30 puts at $2.41 and purchase the Facebook December $32 calls at $2.32
The Net Credit (minus the commission) = $0.09
Here are some points to note from the above trade:
- When Facebook option was last traded at $31.11, the $32 call are about eighty-nine cents out-of-the-money, in the other hand, $30 put becomes $1.11 out-of-the-money.
- The trader should put the bid-ask spread in consideration whenever he is trading. The trader receives bid price when selling and gets ask price when he is buying.
- The trader should also note that he can make use of different option expirations and strike prices.
Why Traders Opts To Use Risk Reversal Strategy
There are many reasons why both amateur and professional traders adopt the use of risk reversal strategy when trading options. The risk reversal strategy can be used as a form of delta hedging. For an instance, a trader who fears that his investment will lost when prices goes down decides to buy a put, if the trader is prepared to limit his upside potential on the underlying assets, he should also finance the purchase of the put with premium he made from the sale of the call. This way, the trader can create a position without an initial cost; hence he is protected from big downside price movements.
Investors also commonly use risk reversal strategy as a way to trading option skew. For instance, if the investor thinks that the implied volatility of puts is too high compared to calls. He may need to sell puts in order to be able to buy calls. This act is known as trading a risk reversal.
Pricing of Risk Reversal
Investors are more interested in the implied volatility levels when pricing a risk reversal as a skew trade than in the real dollar value of the options. A trader needs to consider how accurate a price is in terms of implied volatility before making his decisions.
When Can You Use Risk Reversal Strategy For Your Trades
Here are the four conditions where you can use risk reversal strategy for a chance at greater profits:
- When you need to purchase a stock but require some sort of leverage
- At the early stages of a bull market
- Before the spinoffs in option prices
- When a blue-chip suddenly goes down during strong bull markets
Advantages Of Risk Reversals
- Low Cost: This strategy can be used without an initial cost.
- Favorable risk-reward: This strategy can be used in such a way that there is lower risk and unlimited potential profit.<>
- It can be used in different situations and scenarios.
Disadvantages Of Risk Reversals
Most times, the margin requirements for the short leg of a risk reversal can be quite huge.
There are substantial risks on the short leg.
Speculative risk reversal can result to doubling down on a bearish or bullish position which can be very risky.
Risk reversal option trading strategy overall is a very good strategy when that every trader needs to consider seriously. The advantage that comes with it makes it a worthwhile tool for trading options.