Risk Reversal: Bullish Options Strategy

A risk reversal is an options strategy that creates bullish exposure by selling a put and buying a call. It is essentially a bet that the stock will go up, funded by the premium received from selling downside protection. This strategy is popular among traders who have a strong directional view and want leveraged exposure without paying upfront premium.

What is a Risk Reversal?

A risk reversal consists of two legs:

• Sell 1 out-of-the-money put
• Buy 1 out-of-the-money call

Both options typically have the same expiration date. The put premium received often covers most or all of the call premium paid, creating a low-cost or even credit position.

Bullish Risk Reversal Example

Risk Reversal Profit and Loss Profile

Maximum Profit

Maximum profit is theoretically unlimited (on a bullish risk reversal) because the long call has unlimited upside potential.

Maximum Loss

Maximum loss is substantial. If the stock drops significantly, you are obligated to buy shares at the put strike price. Loss = Put strike - Stock price - Net credit received.

Break-Even Point

For a bullish risk reversal entered at a credit:

Break-even = Put strike - Net credit received

In our example: $95 - $0.50 = $94.50

Why Trade Risk Reversals?

1. Low or Zero Cost Bullish Exposure

Instead of paying premium for a call, you fund it by selling a put. This can result in zero-cost or even a credit to enter.

2. Leveraged Directional Play

If you are confident the stock will rise, the risk reversal gives you more exposure than simply buying calls with the same capital.

3. Stock Acquisition Strategy

If assigned on the put, you buy the stock at a discount (put strike minus credit received). This can be a planned outcome.

4. Expressing Strong Conviction

Risk reversals are for traders with strong directional views. The asymmetric payoff rewards being right significantly.

Risk Reversal vs Synthetic Stock

A risk reversal is similar to synthetic stock but uses different strikes:

• Synthetic long stock: Buy ATM call, sell ATM put (same strike)
• Risk reversal: Buy OTM call, sell OTM put (different strikes)

The risk reversal has a "dead zone" between strikes where the position makes or loses the initial credit/debit, while synthetic stock moves dollar-for-dollar with the stock.

Bearish Risk Reversal

Risk reversals can also be used for bearish views:

• Buy 1 out-of-the-money put
• Sell 1 out-of-the-money call

This profits when the stock falls and loses if it rises significantly.

Risk Reversal as Collar Without Stock

A risk reversal is essentially a collar trade without owning the underlying stock:

• Collar: Long stock + long put + short call
• Risk reversal: Long call + short put (no stock)

If you add long stock to a risk reversal, you get a collar. If you remove the stock from a collar, you get a risk reversal.

When to Use Risk Reversals

• Strong directional conviction: You are confident about the stock's direction
• Willing to own stock: You are comfortable buying shares if assigned
• Want leveraged exposure: You want more upside than buying calls alone
• Low cost entry desired: You do not want to pay significant premium
• Skew is favorable: Put premium is high relative to call premium

When NOT to Use Risk Reversals

• Uncertain direction: This is a directional bet, not a neutral strategy
• Unable to handle assignment: If you cannot buy stock if assigned
• Volatile markets: Large moves either way create significant P/L
• High margin requirements: The short put requires margin

Managing Risk Reversals

Stock Moves Up (Profitable)

• Let the position run if you remain bullish
• Take profits by selling the call if it has gained significantly
• Roll the call to a higher strike to capture more upside

Stock Moves Down (Losing)

• Buy back the put to close before assignment
• Roll the put to a lower strike and later expiration
• Accept assignment and own the stock at an effective discount
• Set a stop loss at a specific loss amount

Stock Stays Flat

• Both options decay toward zero
• Keep the initial credit if entered for a credit
• Consider closing to avoid expiration week gamma risk

Risk Reversal Metrics

Delta

A risk reversal typically has positive delta (bullish). The exact delta depends on the strikes chosen. Further OTM strikes have lower delta.

Gamma

Low gamma when stock is between strikes. Gamma increases as stock approaches either strike.

Theta

Approximately neutral theta when between strikes. Short put theta decay offsets long call theta decay.

Vega

Can be positive or negative depending on the strikes and implied volatility levels at each strike.

Tips for Trading Risk Reversals

• Choose strikes carefully: Wider strikes reduce delta but give more breathing room
• Watch the skew: When puts are expensive, risk reversals become more attractive
• Size appropriately: Account for the potential to own 100 shares per contract
• Have an exit plan: Know when you will take profits or cut losses
• Monitor margin: The short put requires margin that can change
• Consider dividends: If assigned, you become eligible for dividends

Summary

A risk reversal is a directional strategy that sells an OTM put and buys an OTM call to create bullish exposure with little or no upfront cost. The trade profits significantly if the stock rises above the call strike and loses if it falls below the put strike. This strategy is best for traders with strong directional conviction who are willing to own the stock if assigned. Remember that the downside risk is substantial - you are essentially taking on stock-like risk below the put strike.

Learn about related strategies: synthetic long stock and vertical spreads.