Risk Reversals for Stocks Using Calls and Puts

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Risk Reversals for Stocks Using Calls and Puts

The underlying appeal of a risk reversal approach is the large potential payout for a little premium. While risk reversal tactics are frequently employed in the forex and commodities options markets, they are mostly used by institutional traders and seldom by ordinary investors when it comes to stock options.

Risk reversal methods may seem intimidating to a novice option trader, but they may be a highly beneficial “option” for experienced investors who are comfortable with basic puts and calls.

What Is Risk Reversal?

The most basic risk reversal method is to sell (or write) an out-of-the-money (OTM) put option while concurrently purchasing an OTM call option. This is a hybrid of a short put and a long call position.

Because writing the put earns the option trader a set amount of premium, this premium revenue may be utilized to purchase the call. If the cost of purchasing the call exceeds the premium earned for writing the put, the approach will result in a net loss.

If, on the other hand, the premium obtained from writing the put exceeds the cost of the call, the approach yields a net credit. If the put premium received matches the call premium paid, this is a costless or zero-cost transaction. Of course, commissions must be considered, but for the sake of simplicity, we omit them in the instances that follow.

A risk reversal is so named because it reverses the “volatility skew” risk that often faces options traders. Here’s what it implies in the most basic terms. Because of the larger demand for protective puts to hedge long stock holdings, OTM puts often have higher implied volatilities (and so are more costly) than OTM calls. This skew risk is reversed since a risk reversal strategy often comprises selling options with greater implied volatility and purchasing options with lower implied volatility.

Risk Reversal Applications

Risk reversals may be utilized for both speculating and hedging. A risk reversal method may be used to replicate a synthetic long or short position when utilized for speculating. A risk reversal method is used to hedge the risk of an existing long or short position when utilized for hedging.

A risk reversal approach used for speculating has two fundamental variations:

  • Because the risk-reward profile is comparable to that of a long stock position, this is analogous to a synthetic long position. The technique, known as a bullish risk reversal, is advantageous if the stock rises significantly and unprofitable if it falls dramatically.
  • Write OTM Call + Buy OTM Put: This is a synthetic short strategy with a risk-reward profile comparable to a short stock position. This bearish risk reversal technique is beneficial if the stock falls dramatically, but it is unprofitable if it rises abruptly.
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A risk reversal approach used for hedging has two fundamental variations:

  • Write OTM Call + Buy OTM Put: This is a “collar” strategy used to hedge an existing long position. The “costless collar” is a special use of this concept that allows an investor to hedge a long position without paying any upfront premium cost.
  • Write OTM Put + Buy OTM Call: This is used to hedge an existing short position and, like the previous example, may be created for free.

Risk Reversal Examples

Let’s utilize Microsoft Corp to demonstrate the creation of a risk reversal method for both speculating and hedging a long position.

On June 10, 2014, Microsoft closed at $41.11. The MSFT October $42 calls were recently quoted at $1.27 / $1.32, with an implied volatility of 18.5% at the time. The October $40 puts on MSFT were trading at $1.41 / $1.46, with an implied volatility of 18.8%.

Speculative trade (synthetic long position or bullish risk reversal)

  • Buy 5x the October $40 puts at $1.41 and write 5x the October $42 calls at $1.32.
  • Net credit (commissions excluded) = $0.09 x 5 spreads = $0.45

Note these points:

  • With MSFT closing at $41.11, the $42 calls are 89 cents out of the money, while the $40 puts are $1.11 out of the money.
  • In such cases, the bid-ask spread must be considered. When writing an option (put or call), the option writer receives the bid price; however, when purchasing an option, the buyer must pay the ask price.
  • Option expirations and strike prices may also be changed. For example, if the trader believes that a large move in the stock is probable in the one and a half weeks before option expiration, they might select for the June puts and calls rather than the October options. However, although the June $42 calls are significantly cheaper than the October $42 calls ($0.11 vs. $1.32), the premium paid for writing the June $40 puts is also much smaller ($0.10 vs. $1.41).

What is the strategy’s risk-reward payoff? There are three possible possibilities for strike prices very close to option expiry on October 18, 2014:

  1. MSFT is now trading over $42: This is the best-case situation, since this trade is similar to a synthetic long position. In this situation, the $40 puts will expire worthless, but the $42 calls will have a positive value (equivalent to the current stock price minus $42). As a result, if MSFT rises to $45 by October 18, the $42 calls will be valued at least $3. As a result, the total profit is $1,500 ($3 x 100 x 5 call contracts).
  2. MSFT is now trading between $40 and $42: in this instance, the $40 put and $42 call will both expire worthless. Since a marginal credit of 9 cents was obtained upon trade start, this will hardly make a difference in the trader’s purse.
  3. If MSFT is trading below $40, the $42 call will expire worthless, but since the trader is short the $40 put, the strategy will lose the difference between $40 and the current stock price. So, if MSFT falls to $35 by October 18, the transaction will lose $5 per share, for a total loss of $2,500 ($5 x 100 x 5 put options).
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Hedging transaction

Assume the investor currently owns 500 MSFT shares and wishes to mitigate downside risk at the lowest possible cost. (This is a hybrid of a covered call and a protected put.)

  • Buy 5x the October $42 calls at $1.27 and write 5x the October $40 puts at $1.46.
  • Net debit (commissions excluded) = $0.19 x 5 spreads = $0.95

What is the strategy’s risk-reward payoff? There are three possible possibilities for strike prices very close to option expiry on October 18, 2014:

  1. If MSFT is trading over $42, the stock will be called away at the $42 call strike price.
  2. MSFT is trading between $40 and $42: In this case, both the $40 put and $42 call will expire worthless. The investor’s sole loss is the $95 cost of the hedging transaction ($0.19 x 100 x 5 contracts).
  3. When MSFT trades below $40, the $42 call will expire worthless, but the $40 put option will be lucrative, offsetting the loss on the long stock position.

Why would an investor pursue such an approach? Because it is successful at hedging a long position that the investor wishes to keep at a low or no cost. In this case, the investor may believe that MSFT has low upward potential but high downside risk in the short term. As a consequence, they may be ready to forego any potential over $42 in exchange for downside protection below a stock price of $40.

When Should You Use a Risk Reversal Strategy?

Risk reversal tactics are most effective in the following situations:

  • When you truly like a stock but need some leverage: If you truly like a stock, writing an OTM put on it is a no-brainer technique if (a) you lack the cash to acquire it outright, or (b) the company seems to be a bit overpriced and is out of your price range. Writing an OTM put will yield you some premium money in this situation, but you may “double down” on your bullish outlook by purchasing an OTM call with portion of the put-write profits.
  • In the early stages of a bull market: In the early stages of a bull market, good quality equities might soar. During such circumstances, there is a lower danger of getting assigned on the short put leg of bullish risk reversal strategies, although OTM calls may have huge price gains if the underlying equities increase.
  • Prior to spinoffs and other events such as an impending stock split: In the days before a spinoff or a company split, investor excitement often offers significant downside support and results in considerable price increases, creating a perfect situation for a risk reversal approach.
  • When a blue-chip stock falls precipitously (particularly during strong bull markets): During robust bull markets, a blue-chip that has briefly fallen out of favor due to an earnings miss or other unpleasant occurrence is unlikely to remain there for long. Implementing a risk reversal strategy with a medium-term expiry duration (say, six months) might pay off handsomely if the stock recovers during this time.
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Pros and Cons of Risk Reversals

The advantages of risk reversal strategies are as follows:

  • Low cost: Risk reversal procedures are inexpensive to adopt.
  • Favorable risk-reward: While not without dangers, these techniques may be devised to maximize profit while minimizing risk.
  • Risk reversals are applicable in a broad range of trading settings and conditions.

So what are the drawbacks?

  • Margin requirements for the short leg of a risk reversal may be onerous: Margin requirements for the short leg of a risk reversal can be rather considerable.
  • Significant risk on the short leg: The dangers on the short put leg of a bullish risk reversal and the short call leg of a bearish risk reversal are high and may surpass the ordinary investor’s risk tolerance.
  • “Doubling back:” Speculative risk reversals are equivalent to doubling down on a bullish or bearish position, which is perilous if the trade’s premise turns out to be erroneous.

The Bottom Line

Risk reversal tactics may be employed efficiently in a broad variety of trading circumstances due to their very favorable risk-reward payout and cheap cost.

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