What are the characteristics of this option strategy?
Risk reversal trades are strongly directional: buying a call and selling a put creates a synthetic long position (delta near +1.00), while buying a put and selling a call creates a synthetic short (delta near -1.00). It is used by intermediate to advanced traders to take a stock-like position for little or no net premium, because the option that is sold pays for most or all of the option that is bought. The short leg is uncovered, so the position carries the full loss profile of the underlying on the wrong side: a bullish risk reversal loses dollar for dollar all the way down to zero, and a bearish one loses without a fixed limit as the underlying rises.
Is this a bullish, bearish or neutral strategy?
The Risk Reversal Option Strategy is not neutral. It can be built either way, but each version takes a firm side: long call plus short put is bullish, and long put plus short call is bearish. Skew in high implied volatility often makes the option being sold richer than the one being bought, which is why the structure can be put on cheaply, but that discount does not soften the directional exposure. If the stock moves the wrong way, the position loses.
Is this a beginner or an advanced option strategy?
This is an intermediate to advanced option strategy. It requires an understanding of the basic mechanics of options trades, including expiration cycles and the Greeks. Because the short leg is naked, it also requires margin approval for uncovered options, the cash or buying power to take delivery of the stock at the short strike, and position sizing that assumes the underlying can gap straight through that strike overnight.
In what situation will I use this strategy?
The Risk Reversal Option Strategy is best used when an investor already holds a firm directional view and wants stock-like exposure without paying full premium for a long option. The strategy begins with that bullish or bearish view, and the investor sells the option on the side they are willing to be wrong about, financing the option they want to own. Nothing about the structure limits losses on a move in the wrong direction. It is often used as a hedge overlay against an existing stock position, where the other side of the trade is already owned.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
This is a high risk structure. The probability of profit is better than a straight long call, because the premium taken in on the short put pays for most of the long call, so the underlying has to travel far less to reach breakeven than it would to cover a full long call premium. It is not a profit on a flat stock: in the example below a flat MSFT still loses the $2 net debit. The reward is open-ended on the correct side. The loss, however, is not bounded by the premium: the maximum loss on a bullish risk reversal is the put strike plus any net debit paid, or less any net credit received, all the way down to a stock price of zero. A stock that gaps 40% lower on bad news costs the position 40% of the strike, and no leg of the trade caps that.
How is this strategy affected by the greeks?
The Risk Reversal Option Strategy is affected by the delta, gamma, vega, theta, and rho greeks. The deltas of the two legs add rather than offset, giving a combined delta near +1.00, while the gamma, vega and theta of the long call and the short put largely cancel and net to roughly zero at a common strike.
In what volatility regime (i.e VIX level) would this strategy be optimal?
The Risk Reversal Option Strategy is cheapest to put on in a high volatility regime with steep skew, because the out-of-the-money put being sold is priced richly relative to the out-of-the-money call being bought. That is a pricing advantage on entry, not a profit engine. High implied volatility also signals that the market expects a big move, and the position is exposed without limit to a big move in the wrong direction, so a low entry cost is not a reason to size the trade larger.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
Adjusting the Risk Reversal Option Strategy when the trade does not go as planned is relatively straightforward. If the underlying stock price moves against the trader, they can adjust the position by either rolling it out to a higher or lower strike price or converting the position into a different strategy such as a debit spread. Risk on this strategy is not limited to the initial cash outlay. The short put is naked, so the maximum loss is the put strike plus any net debit paid (or less any net credit received), all the way down to zero: with the $280 short put and the $2 net debit in the example below, that is $282 per share, or $28,200 per contract.
Where does this strategy typically fall in the range of commissions and fees?
The Risk Reversal Option Strategy typically falls in the range of low to moderate commissions and fees. The strategy requires two trades to execute, which may carry commissions, as well as bid-ask spreads. The size of the initial cash outlay will also affect the total cost of the trade.
Is this a good option income strategy?
No. The Risk Reversal Option Strategy is a directional substitute for owning or shorting stock, not an income strategy. It does collect premium on the short leg, but that premium is spent buying the long leg, and the position's profit or loss is driven almost entirely by where the underlying goes. Treating the credit as income ignores the open-ended loss sitting behind it.
How do I know when to exit this strategy?
The Risk Reversal Option Strategy should be exited when the trader no longer expects the underlying stock to move in the anticipated direction. Additionally, this strategy should be exited if any of the Greek values move too far out of the trader’s acceptable range. The trader may also exit the position for a modest gain if the premium received exceeds the trader’s expectations.
How will market makers respond to this trade being opened?
Market makers will typically respond to the Risk Reversal Option Strategy by adjusting the bid-ask spread. This will help them to recover some of the costs associated with the trade and to help balance the trader’s risk-reward profile.
What is an example (with calculations) of this strategy?
Assuming MSFT is trading at $285, a bullish investor can create a Risk Reversal Option Strategy by simultaneously buying an out-of-the-money call and selling an out-of-the-money put in the same expiration, with the put strike below the call strike.
To execute this strategy, the investor would do the following:
Buy one out-of-the-money call option with a strike price of $290 and an expiration date of one month from now, paying a premium of $7 per share.
Sell one out-of-the-money put option with a strike price of $280, below the $285 spot, and the same expiration one month from now, receiving a premium of $5 per share.
This example is a net debit of $2 per share: $7 paid for the call less $5 received for the put. The payoff diagram is a straight upward-sloping line, the same shape as owning the stock. The upside is open, and below the $280 put strike the position loses dollar for dollar with the underlying, with the $2 debit added on top.
Here’s how the strategy works:
If MSFT rises above $290 by expiration, the short put expires worthless and the investor keeps its full premium while the long call gains dollar for dollar, so the upside profit potential is unlimited.
The position breaks even at $292 (the $290 call strike plus the $2 net debit). Between $290 and $292 the call is in the money but the trade is still down.
Between $280 and $290 both options expire worthless and the loss is the $2 net debit, or $200 per contract.
Below $280 the short put is in the money and the investor is obliged to buy MSFT at $280. From there the position loses $100 per contract for every $1 MSFT falls, on top of the $200 debit. The short put is uncovered, so there is no floor short of a stock price of zero: the maximum loss is $280 plus the $2 debit, or $28,200 per contract. This is the dominant risk in the trade, and nothing in the structure caps it.
How MarketXLS can help?
MarketXLS is a powerful tool for analyzing risk reversals, credit spreads, and other option strategies. With MarketXLS, traders can analyze the greeks, probabilities, and commissions associated with various option strategies, allowing them to enter into trades with confidence and manage their positions effectively. MarketXLS is a great tool for assessing the risk-reward and probability of success of any option strategy, making it an invaluable asset for traders of all experience levels.
Here are some templates that you can use to create your own models
Risk Reversal Option Strategy
Reverse Iron Butterfly Spread
Search for all Templates here: https://marketxls.com/templates/
Relevant blogs that you can read to learn more about the topic
“Maximizing Your Profits with Out of Money Call Options”
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