How to Construct A Basic Risk Reversal

Instead of buying outright calls or puts, institutional traders might use a basic risk reversal, which is a mix of both calls and puts to structure a position. A basic risk reversal, however, has significantly more risk that simply buying long calls.  It’s a hedge strategy that can protect price movements, but it limits the profits you can make.

So Why Bother With a Risk Reversal?

For one, the sale of puts equalizes the time equation. The time decay that may erode the value of the long calls may be partially or completely offset by the time decay that may erode the puts.

Secondly, risk reversals may potentially take advantage of the volatility skew. Because puts may carry larger premiums than calls of equal distance out-of-the-money, such positions may be initiated at even money or for a credit.

How Do You Construct a Basic Risk Reversal?

You can do so in four simple steps:

  1. Buy calls on the desired stock or contract
  2. Sell puts on the desired stock or contract
  3. Look to initiate the position at even money or for a credit
  4. Manage the risk and position (aka, have an exit plan)

Options are typically bought and sold slightly out-of-the-money, although one can use options that are closer to or further away from the money.

Options having the same expiration date are typically utilized. However, you can use options with different expiration dates.

So What’s the Best Strategy For Me?

When selling naked puts, the position will expose you to unlimited risk down to zero. However, such positions aren’t  for everyone, as you can lose more than your initial investment. You might also have to deal with large and rapidly margin requirements.

Make sure you keep in mind the following before making any decisions:

  •  You may potentially make money on both the long calls and the short puts if the stock or contract rises.
  •  If the market goes sideways, all options may simply expire worthless. In this case, you may not have a loss as the sale of the pits offset the purchase of the calls.
  •  If the market trades sideways and all options expire worthless, you may still have a profit.
  • If the position was initiated at a net credit, that credit may be retained if all options expire worthless. The naked puts sold represent unlimited risk and must be carefully considered and managed.

Make sure you think through how much of a risk you want to take, as option writing isn’t right for everyone.