Understanding How a Risk Reversal Works

Risk reversal can be used as a hedging strategy for options trading. An investor buys one option and writes or sells another within the same expiration month. This type of strategy is designed to help options traders minimize downside risk when taking long or short positions. It’s typically more common to seek risk reversals used when trading options for commodities or forex, though they can also be employed by stock options traders. While risk reversals can offer some advantages to investors, there are some potential downsides to be aware of.

Working with a financial advisor is a sound way to ensure that you have done everything you can to cap the potential risks of your investments.

Options Trading Basics

Options represent an opportunity to buy or sell an underlying asset. This can be a commodity, a stock or another type of security. The option contract specifies whether the investor can buy or sell the asset at a certain price by a certain expiration date. The price at which an option is exercised is the strike price.

There are two basic types of options to understand when discussing risk reversals. These are called call and put options. A call option gives an investor the right to buy an underlying security. A put option conveys the right to sell an underlying security. An option doesn’t require an investor to buy or sell the underlying security.

Options traders can go a step further by going short or long. Investors can take long put, long call, short put or short call positions. With long positions, the assumption is that the underlying security’s price will rise. With short positions, the investor is banking on the underlying security’s price declining.

An option can be out of the money, in the money or at the money. These terms are used to describe an option’s intrinsic vs. extrinsic value. For instance, an out-of-the-money call option means the price of the underlying asset is below the strike price. An out-of-the-money put option means the underlying asset’s price is above the strike price.

For further context, in-the-money call options mean the underlying asset’s price is above the strike price. In-the-money put options mean the underlying asset’s price is below the strike price. At-the-money options mean the underlying security’s price and the strike price are the same. Understanding how long and short option trading works and what it means to be out of the money can help with understanding risk reversals.

Risk Reversal Definition

A risk reversal allows an options trader to hedge their position by buying and selling options simultaneously. These transactions are typically completed with the same expiration month. By using a risk reversal to hedge, an investor may pay a premium to buy an option. But this may be offset by income produced by writing an option. In some instances, the income generated may even result in a credit for the investor.

Risk reversals can be effective for managing risk with stock options trades but they don’t eliminate it entirely. Investors still have to be correct in their guesses about which way an asset’s price will move in order to minimize losses or increase profits. In simple terms, a risk reversal can be highly profitable if the investor is right, but it can amplify losses if he turns out to be wrong.

How Risk Reversals Work

The form a risk reversal takes and how it works can depend on whether the trader is short or long in the underlying position.

A long risk reversal strategy is used for short trading positions. In this situation, the investor would hedge by buying a call option and writing a put option for the same underlying asset. The call option’s value increases, assuming that the price of the underlying asset increases also. In this instance, the rise in value would help to offset a loss on the short position.

When an investor is long in an asset, they’d flip their approach and use a short risk reversal strategy. In this case, they’d write a call option and buy a put option for the underlying asset. If the asset’s price drops, then the value of the put option would increase. This can help to offset losses on the long position.

There are different variations on how risk reversals can be applied to options trading. For example, a common scenario involves writing an out-of-the-money put option and buying an out-of-the-money call option. In this instance, you could make money by taking a bullish approach assuming that the underlying asset’s price increases.

Alternately, you could write an out of the money call and buy an out of the money put. With this strategy, you’re making a bearish move instead since you’re hoping that the underlying security’s price drops.

Risk Reversal Pros and Cons

Risk reversal can be an effective hedging strategy for options traders. On the pro side, you could use this approach to increase profitability while minimizing the potential for losses. Risk reversals can be applied when trading commodities, forex or stocks so it has multiple uses for options traders. And if you’re trading on margin it’s possible to multiply profits even more. But again, you have to be correct in your guesses about which way a stock or security’s price will move. If you’re wrong, you could end up with a sizable loss instead of a profit. Trading options on margin can increase losses and leave you open to the possibility of a margin call.

It’s important to pay attention to what’s going on in the broader market when employing risk reversal strategies. This can help with managing risk. If, for example, the market is shifting from bearish to bullish this might create opportunities to capitalize on rapidly rising stock prices. But you’d still have to watch out for wide pricing swings with individual securities.

The Bottom Line

Risk reversal strategies can be useful to options traders who are interested in more advanced trading strategies. Before diving in, it’s important to understand the basics of how options work. That includes knowing what it means to be long or short in positions and how out-of-the-money options differ from in-the-money or at-the-money options.

Tips for Investing

• Consider talking to your financial advisor about options trading and how to use risk reversal strategies. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. All you need to do to get started and find your personalized advisor matches is answer a few simple questions. If you’re ready, get started now.

• Knowledge is half the battle. Make sure you know what taxes you may have to pay on your investments with SmartAsset’s free capital gains calculator.

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