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.