The risk reversal option strategy: A bullish trade that involves buying a call option or long debit spread and simultaneously selling a put option (which is often sold OTM) at the same expiration date. The risk reversal has a few solid benefits.
For instance, the risk reversal is perfect for those who want to benefit from being long the call options without having to worry about theta decay. The strategy also eliminates the risk of the stock trading sideways. However, it does come with one very substantial risk if the stock trades down. More on that later.
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When Should You Use a Risk Reversal?
There are a few reasons an options trader would want to use a risk reversal, but before you do, you must make sure you are:
- Bullish on the underlying stock
- Able and willing to buy the stock in 100-share lots below your put strike price
- Comfortable with multi-legged options strategies
If you’ve checked all three boxes, you’re ready to take on the risk reversal.
The most advantageous time to take advantage of this unique options strategy is when put skew is smirking at you. We aren’t being coy here – when put skew is said to be in a “smirk” formation, OTM puts are more expensive than OTM calls. It really just means the market is paying extra for protection. Risk reversals take advantage of that by selling those high-priced put options, and using them to finance the purchase of long options! This will give you the best “bang” for your buck.
Additionally, you might consider using the risk reversal when you’re bullish enough on a stock or equity that you would consider buying it if it dropped to a certain price. Again, this is because risk reversals essentially combine a cash-secured put with a long bullish option. Through this unique combination, traders can mitigate theta decay (since cash-secured puts are theta positive and long options are theta negative), and lower their break even price through the credits they receive.
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The “Risk” Involved in Risk Reversals
In short, risk reversals combine a cash-secured put with a long bullish option in order to make a two-pronged, theta-neutral bullish trade. It’s the antithesis of a collar – which involves simultaneously buying a protective put option and selling a covered call option to limit potential losses and gains on a particular stock. However, while collars involve owning 100 shares of stock, risk reversals involve staking 100 shares worth of collateral. That’s the big risk here.
Any time you have a cash-secured put, you have to have the cash to be able to buy 100 shares of stock for each short put, using the strike price as your execution price. If the short put was sold at a strike of $100, you’d best be ready with $10,000. If not, you’d be selling a naked put, not a cash-secured put. And we don’t sell naked options.
How to Trade a Risk Reversal Options Strategy
When trading a risk reversal options strategy, you might have two or three separate legs. Why? Because in a risk reversal options strategy, you will always be selling a short put. However, you have the option of either going long an individual call, or a call debit spread. A call debit spread will limit your potential profit, but offer another theta-positive leg in your trade, as well as another credit! On the other hand, for a higher cost, a simple long call will uncap your potential profit.
Imagine a two-legged risk reversal set up this way:
A long call bought in $XYZ with a $100 strike price for $5.00
A short put sold in $XYZ with a $90 strike price for $4.00
The result: A total debit of -$1.00, a collateral needed of $9,100, and an uncapped potential upside gain if the stock rises above $101.
Curious how it looks inside a real brokerage?
Here’s what a risk reversal order will look like in the form of a three legged call debit spread and cash-secured put, inside the Thinkorswim brokerage.
This imaginary risk reversal was cast on the SPY ETF with the ETF trading at roughly $398. Notice that the expiration dates are all the same. Also, notice there’s only one long option here – the $405 call. At the same time, there is a short $420 call (the short leg of the vertical debit spread), and a short $374 put (a cash-secured put, on its own), leading to a total “debit” (meaning the cost you must pay up front to enter the trade) of -$0.23 (the mid price of the trade).
Risk Reversal Risk Diagram
Recall that the “$0.23” price tag isn’t the only cash a trader must have in order to execute this trade – The trader here would actually have to be holding onto $37,423 dollars (($374*100)+$23) in order to execute this trade without exposing themself to a naked option trade. Let’s look at why that is, with a risk diagram:
This risk diagram shows the technically lop-sided risk-reward of a risk reversal. In fact, the diagram cuts off at the $300 level – theoretically, the owner of the risk reversal takes on risk all the way down to a $0 share price!
So why then would someone own this “unfair” strategy?
For one, the trader taking on this strategy is comfortable owning 100 shares of the SPY ETF at or below the $374 put strike price. For two, the risk reversal’s breakeven price is considerably closer within reach than the risk reversal’s put strike price. If the ETF does nothing, the risk reversal trader will only lose the $0.23 debit they paid to enter the trade. If the ETF soars, the short put expires worthless, and the debit spread expires at full profit. And if the ETF falls, short put acts similarly to a limit-buy order – with the caveat being that the ETF may fall far below that limit price.
Of course, the question in many traders minds is likely: is the risk actually a full $37,400? Probably not.
For the SPY ETF (which represents the S&P 500 and is broadly seen as a barometer for the entire US stock market) to fall to 0, it would likely take a near apocalyptic scenario – the type where people are more interested in trading cans of food than stocks and equities. Still, stock market crashes do happen, and traders who take on this strategy must be prepared for anything – lest they be forced to pick up the phone and answer the almighty margin call. This goes double for traders taking on this strategy on single stocks.
The Bottom Line
Don’t let us scare you away with talks of risks – the risk reversal is a powerful options strategy in the right hands. It can negate theta decay, capture option premium, and give traders access to a two-pronged bullish attack. You just need to make sure you’re comfortable purchasing the shares if push comes to shove.