Risk Reversal

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Risk Reversal

A risk reversal is an options-based strategy used to hedge or express directional conviction while offsetting part or all of the option cost by selling the opposite option. In equity markets it typically consists of buying one side (a put or a call) and selling the other. In foreign exchange markets, “risk reversal” also refers to the difference in implied volatility between similar out‑of‑the‑money calls and puts, a measure of market sentiment.

Key takeaways

  • A risk reversal hedges a position by pairing a purchased option with a written option, reducing upfront cost but often capping upside.
  • For a long underlying position, a typical (short) risk reversal = buy put + sell call. For a short underlying position, a long risk reversal = buy call + sell put.
  • In FX, the risk reversal value = implied vol(call) − implied vol(put); a positive value indicates greater demand (or higher implied vol) for calls versus puts.
  • Variations—ratio and calendar risk reversals—adjust exposure, cost and time decay characteristics.
  • Risk reversals are not risk elimination: losses can occur if the market moves contrary to the intended view or if volatility and transaction costs change unfavorably.

How it works (equity/options view)

  • Structure:
  • Short risk reversal (hedging a long underlying): buy a put and sell a call.
  • Long risk reversal (hedging a short underlying): buy a call and sell a put.
  • Mechanics:
  • The bought option costs a premium; the sold option generates premium income that reduces net cost.
  • Net position may be a debit, credit or close to zero depending on strikes and premiums.
  • The sold option limits profit potential on one side of the market while the bought option provides protection on the other.

Variations

  • Ratio risk reversal:
  • Involves buying and selling unequal numbers of options (e.g., buy two calls, sell one put).
  • Creates asymmetrical payoff and can magnify directional exposure while altering net premium.
  • Calendar risk reversal:
  • Uses options with different expirations (e.g., buy longer‑dated option, sell shorter‑dated option).
  • Exploits differential time decay (theta) and maintains directional exposure with a dynamic cost profile.

Risk reversals in FX markets

  • Definition: the numerical difference in implied volatility between equivalent OTM calls and puts for a currency pair.
  • Interpretation:
  • Positive risk reversal → calls have higher implied vol than puts → market leans bullish for the base currency.
  • Negative risk reversal → puts have higher implied vol → market leans bearish.
  • Use: traders and strategists monitor risk reversals as a gauge of directional bias, demand for protection, and skew in option markets.

Practical example

  • Situation: Long 100 shares of a stock trading at $11.
  • Short risk reversal to hedge: buy $10 put, sell $12.50 call.
  • The sold call’s premium helps pay for the purchased put. If stock falls below $10, the put offsets losses; if stock rises above $12.50, upside is capped at $12.50 (plus premium received).
  • Depending on premium levels, the trade may result in a small net debit (cost) or net credit.

When to use a risk reversal

  • To protect a position while maintaining exposure without fully liquidating the underlying.
  • When you have a directional bias and want to lower the net cost of option exposure.
  • When implied volatility/skew or time decay make offsetting premiums attractive.

Risks and limitations

  • Market direction may be wrong—protection may be insufficient or upside may be unnecessarily capped.
  • Changes in implied volatility can alter option values and P&L independently of the underlying’s price.
  • Transaction costs, wide bid‑ask spreads and low liquidity can erode expected benefits.
  • Complexity increases with ratio or calendar variants; these require active monitoring.

Frequently asked questions

  • Is a risk reversal the same as a collar?
  • They are similar: both pair a bought option with a sold option. “Collar” often implies the cost is minimal or zero, while “risk reversal” emphasizes the directional tilt; in FX “risk reversal” is a vol‑skew metric.
  • Will a risk reversal eliminate risk?
  • No. It manages and shifts risk but does not eliminate it. Losses remain possible.
  • How does implied volatility affect the strategy?
  • Higher implied vol increases option premiums, raising the cost of the bought option and the value of the sold option. Net effect depends on strikes and skew.

Bottom line

Risk reversals are flexible option structures that let traders hedge or express directional views while managing cost through offsetting premiums. They work across equities and FX (the latter as a vol‑skew indicator). Understand strike selection, expirations, implied volatility and liquidity before implementing them—risk is managed, not removed.