A risk reversal involves the sale of an out-of-the-money put option and a simultaneous purchase of an out-of-the-money call option with the same expiration.
It can be established for a minimal cost but requires the underlying to move in order to be profitable or be assigned.
We compare the benefits and drawbacks of this strategy to those of a CSEP and a long call, two other bullish option strategies.
Selling an out-of-the-money cash-secured equity put (CSEP) can be an effective way to generate income while retaining the potential to purchase a stock at a lower price. With this strategy, you sell a put contract, and simultaneously deposit cash in your brokerage account in case you are assigned and are obligated to purchase shares at the put's strike price.
However, by the time the put expires, sometimes the stock price increases more than the premium received from the sale of the put, so it would have been more profitable to have simply bought the stock. One way to potentially avoid this scenario is a risk reversal—a simultaneous sale of an out-of-the-money put option and purchase of an out-of-the-money call option with the same expiration. This strategy offers investors the potential to participate in upside appreciation in the price of the underlying stock. Let's take a look at its benefits and drawbacks.
How does it work?
Both the risk reversal and CSEP strategies involve the sale of a put option, but a risk reversal also requires the simultaneous purchase of an out-of-the-money call option with the same expiration. In essence, you are selling a put on a stock that you would like to own (typically at a lower price) and using the premium you receive to fund the purchase of the call.
Isn't a risk reversal the same as a synthetic long stock position?
In the world of options, a "synthetic long stock" position is created by selling an at-the-money put option and simultaneously purchasing a call option with the same strike price, underlying stock and expiration date. The resulting position shares a similar risk profile as a long stock position: unlimited theoretical gains and losses. The risk reversal strategy is slightly different, in that the strikes selected for the put and call options are out of the money. But neither strategy offers the benefits associated with stock ownership, such as dividends or voting rights.
When to consider a risk reversal strategy
A risk reversal strategy is a bullish option strategy that can typically be initiated for little or no up-front cost. However, similar to a cash-secured equity put, you will typically need to maintain cash in your account equal to the total amount of the potential assignment, in the event that the stock shares are assigned (put) to you. When you are bullish on a stock, you could also consider a CSEP or a long call. Let's see how these two strategies compare in terms of their risk/reward characteristics to a risk reversal.
Source: Schwab Center for Financial Research.
This table shows that the risk reversal strategy shares both benefits and drawbacks with the CSEP and the long call. The risk reversal strategy isn't considered an income generating strategy, such as a CSEP. Additionally, it doesn't share the same risk/reward characteristics as a long call strategy since there's little or no cost to establish it and the impact of time decay is offset by the short put.
Why not buy the stock instead?
Outright purchase of stock carries a slightly different risk/reward profile but is a bullish strategy worthy of consideration. If you believe the current price of a stock represents a good entry point and you are comfortable with immediately participating in the upside and downside price movement then initiating a long stock position may be desirable. If you would prefer to wait for a potentially better entry point but don't want to miss out on the potential upside then a risk reversal strategy might be worthy of consideration.
Risk reversal guidelines
- Select the put strike: Similar to a CSEP, the strike price of the put typically represents a price at which you would feel comfortable owning the underlying security in the event that the stock drops and you are assigned.
- Select the call strike: It is common to choose a call that has a price roughly equivalent to the price of the put. This way the cost of the call is essentially covered by the premium you received from selling the put, and the strategy can be initiated for little or no cost. Equally important in the call strike selection is your individual forecast on the underlying security—determine how high you believe the stock will rise and then consider selecting a strike price that is reasonably below your price target.
- Select the expiration: Risk reversals provide flexibility when it comes to expirations because there typically isn't a significant discrepancy in the cost when you select a different expiration. This occurs because the prices on both calls and puts generally increase as you go further out in time. Consider how long you are comfortable having the obligation of the short put in place or how long you think it may take for the underlying stock to move higher.
Potential outcomes at expiration
A risk reversal strategy essentially creates three price "zones" where the underlying stock will close at expiration:
- Below the strike price of the put: You should expect to be assigned on your short put and take delivery of shares in the underlying security (100 shares per contract). The good news is that your effective purchase price is lower than what you would have paid when the strategy was initiated; the bad news is that you may have an unrealized loss on the investment.
- In between the put and call strike: Both contracts expire worthless and you can assess the current price and outlook of the underlying stock and decide whether you want to continue your pursuit.
- Above the strike price of the call: You have the right to exercise the call and take ownership of the underlying stock or sell the call (hopefully at a profit). If you exercise the call, your effective purchase price of the stock is equal to the strike price plus the net debit paid (or minus the net credit received) when the strategy was initiated.
The profit and loss profile of a risk reversal
Source: Schwab Center for Financial Research.
The stock needs to move above the strike price of the call (plus the net debit/credit associated with establishing the strategy) before achieving a profit or below the strike price of the put before potentially being put the stock because the call and put strikes are out of the money.1 The area in between the strikes may be compared to a mulligan or a second chance to perform an action and re-evaluate the underlying security. When the underlying stock closes between the strike prices, both options should expire worthless. Therefore, no positions are established and the only loss is any cost associated with initiating the trade (which can vary from a slight credit to a slight debit, depending on the premiums of the strike prices you select). Now you can decide what action, if any, you want to take regarding this stock.
Risk reversal in action
Let's assume that you have identified "XYZ" as a stock that you believe will go higher over the longer-term but you do not want to purchase shares at the current price of $14.12. What are some bullish strategies you might consider?
- You could sell a 13.00 or lower strike put and generate some income while you wait to see if XYZ pulls back, but what if the stock moves higher and you miss out on the run?
- You could purchase a 14.00 call and limit your maximum loss (equal to the amount paid for the call), but your effective purchase price (equal to the strike price of the call plus the premium paid) would be higher than $14.12 and the call option would be subject to time decay.
- Instead, you might decide to initiate a risk reversal strategy, targeting the 13.00 strike for the put, the 15.00 strike for the call and January 2014 as the expiration date for both (the current date is August 30, 2013).
From the Trade tool of the StreetSmart Edge® platform, enter XYZ into the symbol field, click on the Options tab and select the "Collar/Combo" strategy from the strategy selector. Then select the January 2014 expiration and 2.00 as the "Range" since you are interested in pairing a 13.00 put with a 15.00 call:
Source: StreetSmart Edge®
In the screenshot above, we can see that the 13.00 XYZ put has a bid of 0.49 and the 15.00 call ask price is 0.58, which indicates that a 13.00 P / 15.00 C risk reversal will currently cost 0.09 (or $9.00 for every contract):1
|Cost of the 15.00 XYZ call:
Premium received from selling the 13.00 XYZ put:
The .09 represents the "market price" for this trade. Looking at a chart of XYZ, along with the three potential expiration "zones," we can see how this strategy may play out based on the performance of XYZ from now up until the January expiration:
Source: StreetSmart Edge.
You can expect to be assigned on your short put at any price below $13.00 at expiration. In this case, your effective purchase price is $13.09 (put strike price + the .09 debit for initiating this strategy). This should be an acceptable outcome since XYZ was trading at $14.12 when the trade was initiated and XYZ is a stock you are willing to own. At any price between $13.00 and $15.00 at expiration, both options should expire worthless and you will lose the $9.00 spent to execute this trade. At any price above $15.00, you have the option of either exercising your call option and taking delivery of XYZ at an effective cost of $15.09 or selling the call options. Ideally, XYZ would be trading above $15.09, which would result in a profit.
Similar to other option strategies, a risk reversal carries its own unique blend of benefits and drawbacks. You might want to consider a risk reversal if you're looking to purchase a stock at a lower price while maintaining the possibility of participating in any upside appreciation of the stock.
1. For the sake of simplicity, the examples shown do not take into consideration commission and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of the strategies discussed. Please consult your tax advisor for more information on potential tax implications.