Risk Reversals for Stocks using Calls and Puts
A “Risk Reversal Strategy” offers a big potential pay-off for very little premium. While risk reversal strategies are widely used in the forex and commodities options markets, when it comes to equity options, they tend to be used primarily by institutional traders and seldom by retail investors. Risk reversal strategies may seem a little daunting to the option neophyte, but they can be a very useful “option” for experienced investors who are familiar with basic puts and calls.
Risk reversal defined
The most basic risk reversal strategy consists of selling (or writing) an out-of-the-money (OTM) put option and simultaneously buying an OTM call. This is a combination of a short put position and a long call position. Since writing the put will result in the option trader receiving a certain amount of premium, this premium income can be used to buy the call. If the cost of buying the call is greater than the premium received for writing the put, the strategy would involve a net debit. Conversely, if the premium received from writing the put is greater than the cost of the call, the strategy generates a net credit. In the event that the put premium received equals the outlay for the call, this would be a costless or zero-cost trade. Of course, commissions have to be considered as well, but in the examples that follow, we ignore them to keep things simple.
The reason why a risk reversal is so called is because it reverses the “volatility skew” risk that usually confronts the options trader. In very simplistic terms, here’s what it means. OTM puts typically have higher implied volatilities (and are therefore more expensive) than OTM calls, because of the greater demand for protective puts to hedge long stock positions. Since a risk reversal strategy generally entails selling options with the higher implied volatility and buying options with the lower implied volatility, this skew risk is reversed.
Risk reversal applications
Risk reversals can be used either for speculation or for hedging. When used for speculation, a risk reversal strategy can be used to simulate a synthetic long or short position. When used for hedging, a risk reversal strategy is used to hedge the risk of an existing long or short position.
The two basic variations of a risk reversal strategy used for speculation are:
Write OTM Put + Buy OTM Call; this is equivalent to a synthetic long position, since the risk-reward profile is similar to that of a long stock position. Known as a bullish risk reversal, the strategy is profitable if the stock rises appreciably, and is unprofitable if it declines sharply.
Write OTM Call + Buy OTM Put; this is equivalent to a synthetic short position, as the risk-reward profile is similar to that of a short stock position. This bearish risk reversal strategy is profitable if the stock declines sharply, and is unprofitable if it appreciates significantly.
The two basic variations of a risk reversal strategy used for hedging are:
Write OTM Call + Buy OTM Put; this is used to hedge an existing long position, and is also known as a “collar”. A specific application of this strategy is the “costless collar,” which enables an investor to hedge a long position without incurring any upfront premium cost.
Write OTM Put + Buy OTM Call; this is used to hedge an existing short position, and as in the previous instance, can be designed at zero cost.
Risk reversal examples
Let’s use Microsoft Corp to illustrate the design of a risk reversal strategy for speculation, as well as for hedging a long position.
Speculative trade (synthetic long position or bullish risk reversal)
Write the MSFT October $40 puts at $1.41, and buy the MSFT October $42 calls at $1.32.
Net credit (excluding commissions) = $0.09
Assume 5 put contracts are written and 5 call option contracts are purchased.
Note these points –
With MSFT last traded at $41.11, the $42 calls are 89 cents out-of-the-money, while the $40 puts are $1.11 OTM.
The bid-ask spread has to be considered in all instances. When writing an option (put or call), the option writer will receive the bid price, but when buying an option, the buyer has to shell out the ask price.
Different option expirations and strike prices can also be used. For instance, the trader can go with the June puts and calls rather than the October options, if he or she thinks that a big move in the stock is likely in the 1½ weeks left for option expiry. But while the June $42 calls are much cheaper than the October $42 calls ($0.11 vs. $1.32), the premium received for writing the June $40 puts is also much lower than the premium for the October $40 puts ($0.10 vs. $1.41).
What is the risk-reward payoff for this strategy? Very shortly before option expiration on October 18, 2014, there are three potential scenarios with respect to the strike prices –
MSFT is trading above $42 – This is the best possible scenario, since this trade is equivalent to a synthetic long position. In this case, the $42 puts will expire worthless, while the $42 calls will have a positive value (equal to current stock price less $42). Thus if MSFT has surged to $45 by October 18, the $42 calls will be worth at least $3. So the total profit would be $1,500 ($3 x 100 x 5 call contracts).
MSFT is trading between $40 and $42 – In this case, the $40 put and $42 call will both be on track to expire worthless. This will hardly make a dent in the trader’s pocketbook, since a marginal credit of 9 cents was received at trade initiation.
MSFT is trading below $40 – In this case, the $42 call will expire worthless, but since the trader has a short position in the $40 put, the strategy will incur a loss equal to the difference between $40 and the current stock price. So if MSFT has declined to $35 by October 18, the loss on the trade will be equal to $5 per share, or a total loss of $2,500 ($5 x 100 x 5 put contracts).