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Risk Reversal
Danny Khoo
Sales Trader
Summary: Risk reversal is a multi-leg derivative strategy that utilizes both call and put options to create more dynamic pay offs than directly buying the underlying. One of the most basic risk reversal strategies is to sell an out of the money put option and simultaneously buy an out of the money call option which is typically used when a trader/investor is short a stock. In this article, we will focus on using the risk reversal strategy to accumulate shares.
Using the Risk Reversal Strategy to Build an Equity Portfolio
Good investors often use the popular cash secured puts strategy to buy stocks. However, the users of this strategy can face the risk that the stock rallies higher without any retracement, therefore missing out on the opportunity to buy the shares at their desired price. In such instances, these investors would not be able to participate on the upside of the stocks they were bullish on.
In order to avoid such a scenario, investors can look to buy an out of the money call option with the same expiration date using their premium gained from the sale of the put option. This combination of selling a cash secured put and buying a call option is called a Risk Reversal.
Risk Reversal = Sell an out of the money (OTM) put option + Buy an out of the money (OTM) call option with the same expiry date
Legend
Kc = Strike for out of the money (OTM) call option
Kp = Strike for out of the money (OTM) put option
In this pay-off diagram, Kp represents the strike for selling the OTM put option while Kc represents the strike for the long call option. The cost of a symmetrical OTM put option and OTM call option can differ depending on a variety of factors including the level of interest rates and market sentiment.
When the price of the stock remains between Kp and Kc at expiry, the payoff would be the difference between the premium received from selling the put option and the premium paid for buying the call option. If the price of the stock rises above Kc, then the pay-off would be similar to being long from the price of Kc + the net premium received if any. Conversely, if the stock falls below Kp, the pay-off would be similar to being long from Kp + the net premium received if any.
Let’s say Apple is trading at $170 now. A trader wishes to buy 100 Apple shares at the price of $160. Instead of placing a limit buy, he sells an OTM put option at strike 160 expiring in 1 month for a premium of $3. Concerned that Apple might rally continuously and not fall below the price of $160, he simultaneously bought an OTM call option at strike 180 for $1.60 with the same expiry date. The cost of the call option ($1.60) was completely offset by the premium received from the sale of the put option. The trader receives a net premium of $1.40 per share.
Scenario 1: Apple goes below $160
The investor would be assigned Apple shares at $160. Breakeven point = $160 – $1.40 = $158.60.
Scenario 2: Apple goes above $180
The investor would not be assigned any Apple shares. Since he is long a call option at strike 180, the trader is able to exercise this call option to buy Apple shares at $180. Breakeven point = $180 - $1.40 = $178.60.
Scenario 3: Apple trades between $160 and $180The investor would not be assigned any Apple shares nor will he be buying Apple shares through an option exercise. Premium received from option strategy = $1.40/share
Summary
The risk reversal is a useful strategy in an investor’s toolkit. This is especially so for stock investors who wish to accumulate shares by selling puts while still retaining upside potential if the stock rallies continuously without falling below the put strike. Investors who wish to retain this upside can do so by buying an out of the money call option using some proceeds from the put option sale. However, if investors feel confident that the stock will trade sideways, then they can save some premium by utilizing the cash secured puts strategy (only sell the put option).