Guide to Risk Reversal

Risk reversal refers to two distinct concepts: an options hedging strategy in stock trading, or a measure of volatility in forex trading.

From a stock market perspective, you can use a risk reversal option strategy by buying and selling options to protect either a long or short position from risk, though it also limits potential profits.

Risk reversal is also used in foreign exchange trading (forex, or FX) with a slightly different definition. There, risk reversal refers to the difference in implied volatility between call and put options. This can give forex traders an idea of the overall market conditions.

What Is a Risk Reversal Option Trade?

Risk reversal is an options strategy that allows you to protect either a long or short position in a stock by buying put or call options to hedge your position. If you are long a stock, you can buy an out-of-the-money put and sell an out-of-the-money call option to help offset potential losses from adverse movements in the stock. If you are short a stock, you can use a risk reversal trade by selling an out-of-the-money put and buying an out-of-the-money call option contract.

How Does Risk Reversal Work?

Here is how options traders use risk reversal options, and how you might use them to hedge a position that you hold. It’s important to note that while risk reversal can hedge a position, it does not eliminate all risk and may result in losses should the price move unfavorably.

Setup

How you set up a risk reversal depends on whether you are long or short the underlying stock. You’ll want to use both a call and put option contract in each case, but which one you sell and which you buy depends on if you are long or short.

If you are long a stock, you will hedge by writing (or selling) a call option and purchasing a put option. If you are short a stock, you will do the opposite — selling a put option and buying a call option that expires at the same time.

Profit/Loss

Let’s examine a scenario where you are long a stock and want to use risk reversal to hedge some of the risk in your position. So you sell an out-of-the-money call option and buy an out-of-the-money put option, usually at a net credit to yourself.

If the stock’s price goes up past the strike price of your call, you will profit based on the increased value of your stock holding. Your maximum loss occurs if the stock price declines below the strike price of the put option, reduced by the net premium you receive from executing the strategy.

Breakeven

Because you generally hold the underlying stock as well as the option when using risk reversal, there is not a specific breakeven price.

Exit Strategy

Often when using a risk reversal strategy, you will keep repeating the process each month as new options expire. That way you can continue to hold the underlying stock and collect the net premium from your options each month. One of your options may expire in the money, depending on stock price movements. At that point, you’ll need to decide whether to adjust or close your position.

Maintaining a Risk Reversal

Maintaining your risk reversal will depend on the movement of the underlying stock. In an ideal situation, the stock will not make any drastic movements. If the stock’s price closes between the strike price of your call and put options, both will typically expire worthless. That will allow you to continue to use the risk reversal strategy and collect an additional premium.

Risk Reversal Example

Let’s say you are slightly bullish on a stock that is trading at $80 per share. You own 100 shares of that stock and want to protect against risk. You can use the risk reversal strategy by buying a $75 put and selling an $85 call through your brokerage. Prices will vary depending on the delta or theta of the options, but you may receive a slight credit.

If the options expire with the stock in between $75 and $85, both financial instruments will expire worthless. Then you can continue the strategy by buying another put and selling another call. If the stock price rises above $85, your call option will be exercised, and you will close your stock position with a slight profit. This strategy reduces your exposure to downward price movements of the stock below $75, but does not fully eliminate risk. Additionally, put premium could cut into returns as the value of the put option declines over time, potentially offsetting gains from the hedge.

Forex Risk Reversal

Risk reversal has a slightly different meaning in the world of forex trading, having to do with the volatility of out-of-the-money call or put options. In forex trading, positive and negative risk reversal figures reflect the sentiment of traders and their expectations for future price direction.

A positive risk reversal is when the volatility of call options is higher than that of the corresponding put options. A negative risk reversal is when the volatility of put options is higher than that of call options. This information can help traders decide on which strategies might be more effective.

The Takeaway

The risk reversal options strategy is a way to mitigate potential losses from market volatility when trading options to hedge a position in the stock market. In forex trading, risk reversal refers to differences in implied volatility between call and put options. Understanding how different options strategies work can help you better understand the stock market.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

FAQ

Why is it called risk reversal?

The risk reversal strategy gets its name because it allows investors to mitigate or reverse the risk you have from a long or short stock position. If you’re slightly bullish on a stock, you can use risk reversal to protect you against downward movement on the stock.

How are long and short risk reversal different?

With a long risk reversal, you are hedging against a short position in the underlying stock. You can do this by purchasing a call option and funding that call purchase by selling a put option. In a short risk reversal, you are mitigating the risk of a long position by selling a call and buying a put option.

How can you calculate risk reversal?

In forex trading, you can calculate the risk reversal by looking at the implied volatility of out-of-the-money call and put options. If the volatility of calls is greater than the volatility of the corresponding put option contracts, there is positive risk reversal, and vice versa.

Photo credit: iStock/Likoper

SoFi Invest®