How a Risk Reversal Options Strategy Works

How a Risk Reversal Options Strategy Works

Key Takeaways

    For stock investors, having a risk reversal options strategy can potentially provide protection against significant portfolio losses while also limiting the upside potential

    Depending on the strike prices you choose, a risk reversal strategy can sometimes pay for itself and potentially provide some income

    Studying risk reversals can help new traders learn how multi-leg strategies work 

Are you long a stock you think has good upside potential in the near term, say over the next couple of months? What if a sudden market setback happens and it falls in price after a bad earnings report or negative guidance from the company? You might be looking for a way to defend your stock position against downside risk.

One typical way is a stop order. But what if you could limit losses if a trade doesn’t go your way while also having a set target price for a profitable exit? For that, an option trader might consider placing an options trade using a risk reversal strategy to manage their open stock position.

How does a risk reversal strategy work?

A risk reversal is a multi-leg options strategy that uses both a call and a put, sometimes referred to as a collar.

The position—long or short an underlying stock or exchange-traded fund (ETF)—will determine whether the trader might be buying or selling the put and the call.

“Investors often use a risk reversal options strategy to generate income by purchasing one leg at a lower price and selling the other at a higher premium, in what’s also known as a net-credit spread options strategy,” said Kevin Hincks, senior strategist at Charles Schwab.

Let’s say the trader wants to create a risk reversal for an underlying long position—meaning they own the stock—and they decide to use a short risk reversal strategy to protect that position. Here’s how that order might be placed.

The option trader might buy a downside, out-of-the-money (OTM) put option well below the current market price, while selling an OTM call option at a strike price well above the current price—and with a higher premium that allows for a potential credit. The trader would want both to have the same expiration date. OTM, or out of the money, refers to a strike price that is well away from the current market price, both higher (on the call side) and lower (on the put side).

For a short position, the option trader might do the opposite and use a long risk reversal strategy where they buy an OTM call, which would work similar to a stop order, and simultaneously sell an OTM put, which could net a credit.

Understanding potential gains and losses with risk reversals

With a risk reversal, the trader would be buying one option and selling another at a higher price for a net credit premium upfront. The rest of the potential gain or loss will come from market price movements that could happen for or against the underlying position.

For example, let’s say an option trader is long 100 shares of stock XYZ at the current market price of $75. To implement a risk reversal, the trader could buy an OTM downside put at a 65 strike, which would act as downside protection for the underlying long stock position. Then, they’d simultaneously sell an OTM 80 upside call, which would act as the price at which they’re willing to sell the shares. The sold 80-strike call option can be assigned at any time during the life of the contract, so the holder of the shares must be willing to sell the stock at that strike at any time up to and including expiration. Both options should have the same expiration date.

Many option traders pick the strike prices so that when they sell the call, the call earns more than the cost of the put. For example, a net credit premium of $0.71, or $71 cash premium ($0.71 x 100 shares per options contract = $71).

In addition to the $71 premium received, the trader would have $5 upside potential to the 80 upper strike of the call for a potential total gain of $571 (100 shares x $5 + $71 premium = $571). The maximum loss would be $929 if the 65 put strike was exercised ([100 shares x $10 = $1,000 market loss] + $71 premium received = $929 maximum loss). Keep in mind that multiple-leg options strategies will involve multiple transaction costs. Also, commissions, taxes, and transaction costs are not included in this discussion, but they can affect the final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

How risk reversals can help avoid slippage

A risk reversal strategy can be a more effective way to enforce the price levels you want to set—take profit and stop loss—and it’s all about avoiding something called “slippage.”

Slippage happens when your order result is different from the price you sought. For instance, say you set a stop order for a long position in XYZ at $35. If the market is moving fast and it drops through your stop level, your stop order might get filled at $34.95 or lower. That $0.05 difference is the slippage. That couldn’t happen with an options strategy where the put is bought at a selected price—such as a strike price of $35—and if the put is exercised, the stock is sold at that specific price.

That’s why a risk reversal strategy can be more effective than stop orders or even a precise price alert you might set. You might not hear a price alert or be in front of the trading platform when the price alert is received.

“By the time you’re able to access the market, the price may have moved significantly from where you wanted to take action, such as stop out or take profit,” Hincks said. “That can’t happen with a risk reversal strategy, which has contractually fixed strike prices over a specified time frame.”

It’s always important to remember that options carry a high level of risk and are not suitable for all investors. If you’re new to options trading or are considering more complex strategies, consider reviewing the fundamentals.

A closer look at a potential risk reversal options strategy

As with any trade or investment, there’s research to be done to find a potential stock that fits the trader’s market view and risk tolerance. Whether your approach is fundamental or technical, you may find a stock you think has the potential to perform well in the near future like a month or two.

Conversely, you might find a stock that has downside potential, meaning you’re expecting it to drop in price—so you may want to establish a short position in that stock or ETF. Keep in mind, however, that short selling is an advanced trading strategy that involves potentially unlimited risks and must be done in a margin account. Margin trading increases your level of market risk.

“While investment selection is the critical first step, it’s also where you’ll begin managing risk,” Hincks said. This is when a risk reversal strategy may come in handy for option traders. By combining the legs, the strategy covers the long position, protecting it from losses beyond a certain point, while also establishing a price where a trader can exit the trade profitably.

For example, say an option trader is thinking of buying a stock, currently trading at $110.70 per share, because they think that particular stock has near-term upside potential. But they also don’t want to have an exposed long position subject to market downturns during the holding period—one month in this example—so the trader may want some form of downside protection.

The trader’s choices are limited to a stop sell order, a price alert, buying a put option, or a risk reversal options strategy.

Figure 1 is an example of a hypothetical option order that shows what risk reversal options trade setups look like on thinkorswim. The first step is to establish the long position by buying the long underlying position of 100 shares of stock and then buying and selling the option legs. To construct a short risk reversal strategy, the trader here is setting up an order to buy an OTM put and sell an OTM call. 

How a Risk Reversal Options Strategy Works

FIGURE 1: PUTTING IT TOGETHER. Source: thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Hincks explained that if the example trade above “goes as intended, the short risk reversal strategy will allow gains on the long underlying position up to the OTM 115 call, while simultaneously protecting the downside of the long position with the 105 put.” So, the maximum gain is if the price reaches the 115 call where the short call will most likely be assigned and the trader would have to sell their long stock holding, netting a $4.30 gain on the stock plus the $0.71 premium on the options ($4.30 + $.71 = $5.01 per share or $501 in cash). The maximum loss, excluding transaction costs, would be if the price fell to the 105 put and the put was exercised for a loss of $5.70 per share, plus the $0.71 premium received or a total of $499 cash.

But what if the trader expected the price of the underlying to fall in the coming weeks? As an example, to apply a long risk reversal strategy to a short underlying position, the option trader would do the opposite of above and purchase an OTM call and sell an OTM put option, hopefully at a premium or net credit.

Potential obstacles

Keep in mind a few things about this strategy. The short risk reversal strategy limits the upside potential of the long stock to the short call option. Also, the downside protection is limited to the 105 strike and the expiration date of the options contract, which should be the same for all legs of the strategy. This can be a helpful strategy; however, it requires active monitoring and is considered a complex multi-leg strategy.

So, accuracy and solid research are paramount in any options strategy’s execution, even a strategy intended to limit risk from the outset. As you study risk reversals but may not be ready to place one in an actual trade, an alternative based on the above example may be to place a stop order at $105 to limit downside risk to $570, not counting any slippage that may occur.

Keep in mind that the thinkorswim platform offers the opportunity to practice this type of trade with its paperMoney® virtual trading feature before placing any trade in a live account.

Bottom line

A risk reversal is a common options strategy used to hedge long or short positions. However, keep in mind, hedging and other protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. The most basic approach is to get to know a stock you think has upside potential down the road, and if you determine it warrants a long position, consider using a risk reversal strategy to cover it.

Leave a comment