What is a 'Risk Reversal'

A risk reversal is a hedging strategy that protects a long or short position by using put and call options. This strategy protects against unfavorable price movements in the underlying position, but limits the profits that can be made on that position. If an investor is long a stock, they could create a short risk reversal to hedge their position by buying a put and selling a call on that stock. 

In foreign exchange (FX) trading, risk reversal is the difference in implied volatility between similar call and put options, which conveys market information used to make trading decisions. 

Breaking Down the 'Risk Reversal'

Risk reversals are also known as protective collars. Their purpose is to protect or hedge an underlying position using options. One option is bought and another is written. The bought option requires the trader to pay a premium, while the written option produces premium income for the trader. This income reduces the cost of the trade, or even produces a credit. While the written option reduces the cost of the trade (or produces a credit), it also limits the profit that can be made on the underlying position.

Risk Reversal Mechanics

If an investor is short an underlying asset, the investor hedges the position with a long risk reversal by purchasing a call option and writing a put option on the underlying instrument. If the price of the underlying asset rises, the call option will become more valuable, offsetting the loss on the short position. If the price drops, the trader will profit on their short position in the underlying, but only down to the strike price of the written put.

If an investor is long an underlying instrument, the investor shorts a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying instrument. If the price of the underlying drops, the put option will increase in value, offsetting the loss in the underlying. If the price of the underlying rises, the underlying position will increase in value but only up to the strike price of the written call.

Risk Reversal Example

If an investor is long a stock at $12 and wants to hedge that position, they could initiate a short risk reversal. The stock currently trades near $12.

They could buy an $11 put option and sell a $13.50 call option. Since the call option is further out of the money (OTM), the premium received will be less than the premium paid for the put option. Thus, the trade will result in a debit.  Under this scenario, the trader is protected against any price moves below $11, because below this the put option will offset further losses in the underlying. If the stock price rises, the trader will only profit on the stock position up to $13.50, at which point the written call will offset any further gains in the stock.

Foreign Exchange Options Risk Reversal Example

A risk reversal in forex trading refers to the difference between the implied volatility of OTM calls and OTM puts. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the FX market and convey information to make trading decisions.

RELATED TERMS
  1. Call On A Put

    A call on a put refers to a compound option where there is a ...
  2. Long Put

    An options strategy in which a put option is purchased as a speculative ...
  3. Stock Option

    Stock options give the holder the right to buy or sell shares ...
  4. Collar

    An options collar is used as a protective strategy on an existing ...
  5. Naked Position

    A naked position is a securities position, long or short, that ...
  6. Seller

    A seller is an entity who writes an option contract and collects ...
Related Articles
  1. Trading

    Risk Reversals for Stocks Using Calls and Puts

    Risk reversal strategies can be a very useful “option” for experienced investors who are familiar with basic puts and calls.
  2. Managing Wealth

    Practical And Affordable Hedging Strategies

    Hedging offers a cost-effective way to transfer risk.
  3. Trading

    Strategies for Trading Volatility With Options (NFLX)

    These five strategies are used by traders to capitalize on stocks or securities that exhibit high volatility.
  4. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  5. Managing Wealth

    Offset Risk With Options, Futures And Hedge Funds

    Though all portfolios contain some risk, there are ways to lower it. Find out how.
  6. Investing

    Why Some Investors Hedge With Puts and Calls

    Learn why investors turn to hedging using puts and calls versus stock to reduce risk. Find out the best time to sell calls or buy puts for your portfolio.
  7. Investing

    Why Options Trading Is Not for the Faint of Heart

    Trading options is not easy and should only be done under the guidance of a professional.
  8. Trading

    Pick The Right Options To Trade In Six Steps

    A six-step approach to finding the right option to trade for our risk tolerance and strategy.
  9. Trading

    How To Profit From Volatility

    We explain four key strategies to profit fom volatility in markets.
RELATED FAQS
  1. Can I make money using put options when prices are going up?

    It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using ... Read Answer >>
  2. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  3. What is the difference between in the money and out of the money?

    Learn how the difference between in the money and out of the money options is determined by the relationship between strike ... Read Answer >>
  4. How does implied volatility impact the pricing of options?

    Learn about two specific volatility types associated with options and how implied volatility can impact the pricing of options. Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center