Risk Reversal is an option trading strategy mainly used for hedging purposes. This strategy is used by traders only as it requires very good understanding of options trading.
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About Risk Reversal Option Strategy
Risk Reversal option trading strategy is a kind of hedging strategy. It protects a long or short position with the use of puts and calls.
We use it for protection against any unfavorable movements of price in the underlying position. However the profits that we could have made in that position are less.
Risk Reversal basically can be in two meanings. In forex options trading, it illustrates the difference between call options and put options in volatility.
Here, it does not convey the meaning of a trading strategy, but of a measurement used for analyzing sentiment in the market.
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Positive Risk Reversal
In this sense, a positive risk reversal depicts that the market in the underlying security is elevating. Here, the calls become costlier than the puts.
In the case of negative risk reversals, on the other hand, there is a concern about the market going downward.
It is the second meaning of risk reversal that we express as hedging strangely. This is generally in use among commodities traders for protecting their owned assets from an unfavorable price movement.
The strategy happens by selling out of the money calls and buying out of the money puts. This is done considering the underlying security already owned.
In such a case, there is a lesser chance that the security would fall. This is because there would be enough profits.
It is specifically in case of falling below the strike price of the put options. This would be enough to cover up any further losses that might be experienced.
However, the problem here lies in the chance of limited profits in case the security goes up. If this rise of security passes the strike price of the call options, the underlying security can be called away.
We suggest that the Risk Reversal strategy can be considered if the trader has an owned asset that has a chance of increasing moderately in price but with the consideration of limiting any losses in case of falls in price.
There aren’t many costs to put on with the strategy. The main technique here is to cover the cost of put bought with the money obtained by writing the calls.
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Usage of Risk Reversal Option Trading Strategy
The Risk Reversal strategy offers protection for investors in the short position with the underlying asset from a rising stock price.
Risk Reversal can be used in case of concerns regarding the stock price of a short position that is trading at a higher price. In such a scenario, the investor can use an upside call and cover up the cost by selling a downside put.
The Risk Reversal strategy could also be used for carrying out a fierce bull trade. Since a higher strike price call option is being bought and the premium paid is financed by selling an Out of The Money put option, there would be an occurrence of a bull trade for close to no cost or even credit.
If the predictions of the stock trading in higher price stay, the short put will become worthless on the long call. The long call will have an increased value which will provide a good margin of profit.
However, if the prediction goes wrong the investor would have to buy the stock at a short put strike price.
This will put the investor in a highly risky situation which could cause losses. Here, the better option would be to sell the stock lower than that used by the investor to open the risk reversal.
Risk Reversal can also be used before spin-offs and imminent stock split. In such cases, the enthusiasm of the investor would give great downside support resulting in a good margin of price gain.
This would give a great scenario for initiating the risk reversal strategy.
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Mechanism of Risk Reversal
If the trader is in a short position with an underlying asset, he can hedge by a long risk reversal. This can be done by purchasing a call option and writing a put option on the underlying instrument.
In this case, an increase in the price of the underlying asset will make the call option more valuable, thus taking off the loss on the short position.
On the other hand, if there is a fall in prices, the trader can turn profits in the short position in the underlying. However this can only be done to the level of the strike price of the written put.
Now, if the trader is in a long position with the underlying asset, he can short a risk reversal in order to hedge the position by writing a call and purchasing a put option on the underlying instrument.
In case of a decrease in the price of the underlying, there will be increased value for the put option, which will cover the loss in the underlying.
In case of elevation of the underlying, it will increase in value. This will only rise up, to the strike price of the written call.
Risks Reversal in Forex
As mentioned, Risk reversal could have a different angle in forex. Here, it suggests the difference between the implied volatility in the Out of the Money ( OTM) calls as well as OTM puts. A rise in demand for the options contract will lead to a rise in volatility and price.
A positive risk reversal would mean that the volatility will be higher for calls than similar puts. This suggests that there would be more chances for a rise in the currency than drops. The opposite would happen in the case of negative risk reversal.
Hence, risk reversal becomes a means of measuring the position in the forex market and further to collect and transfer data for making trading decisions.
Example of Risk Reversal Option Strategy
Consider that a trader is in a long position at Rs.11. He is considering of hedging his position. This could be done by starting a short risk reversal.
If the stock trade currently occurs near Rs.11, the trader can buy a put option of Rs.10 and sell a call option of Rs.12.50.
Here, since the call option is Out of The Money, the premium we have would be lesser than that paid for the put option.
Here, the trader would be in debit with the trade. In such a case, the trader stays safe from prices that move below Rs.10 as the put option can cover further losses in the underlying.
In case there is a rise in the stock position, say up to Rs.12.50, the written call will be above any gains in the share prices.
Profits or losses gained
The scopes for gaining maximum profits remains unlimited with the upside call allowing investors to continue to make money along with the higher trade of stock trades.
There would also be unlimited maximum losses, at least down to zero, as there would be drops in stock price. The losses build upon the short put continuously.
Advantages and Disadvantages
The Risk Reversal strategy has its own pros and cons. One great benefit that could be considered is the low cost it demands for implementation.
The risks give a chance of providing an unlimited potential profit. There are also a large number of situations for initiating the risk reversal strategy.
The drawbacks also are numerous. The margin requirements often could be substantial. There would be co miserable risks on the short leg. This might even be higher than the risk tolerance of the trader.
There are chances of doubling down on bullish or bearish positions. This will be risky in case there is a wrong prediction for the movement of the trade.
Applications of Risk Reversal Strategy
We could use risk reversal for speculation or for hedging. In speculation, it comes of use in creating a synthetic long or short position. In the case of hedging, it helps to hedge the visible risk caused by an existing long or a short position.
Risk Reversal is what we use in two different manners. It is a position that helps traders to gain extremely high profit if there is a correct implementation.
However, in the chances of wrong execution, it could bring significant losses to the trader.
Risk Reversal Option Trading Strategy: Conclusion
The Risk Reversal strategy offers very less sensitivity to changes of implied volatility because it consists of a short option and a long one.
The risk reversal strategy is what the experts use in trading. It would be better for beginners to not give a try on the strategy as there are chances of experiencing huge losses in case the trade moves against the investor.
It is best for experienced traders to experiment.
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