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Risk Conversion - An Option Trading Strategy


Risk Conversion - An Option Trading Strategy

In today's article, we shall learn about the Risk conversion option strategy. It is an advanced options trading strategy used by experienced traders only. Traders use this strategy in a bullish to bearish market to make a profit. In this strategy traders buy a call option contract and sell a put option contract or buy a put option contract and sell a call option contract. Traders use this strategy to limit their downside risk and still want to benefit from the underlying asset's price movement.


Market Scenario of risk conversion:

This strategy can be best suitable in a highly volatile market, in which the price of the underlying asset can move in any of the directions. In short, when traders are not sure about the price movement of the stock, they can use a risk reversal strategy.


How to enter the risk reversal options strategy:

Depending upon the market outlook, a trader has two options to enter the strategy.

  • In case a trader is expecting the market to be bullish, in such case, the trader buys a call option contract and sells a put option contract.

  • In case the trader is expecting the market to be bearish, in such case, the trader sells a call option contract and buys a put option.

  • Both have the same underlying stock and the strike price.

Highest profit to the trader using risk reversal strategy:

As we said, a trader is not sure about the movement of the underlying asset's price; thus, profit can either be limited or can be unlimited. It all depends on the price movement's direction. If the price moves as expected, the trader can have unlimited profit; if not, then the loss is limited. In order to calculate the profit, traders need to subtract the premium amount paid for the options contract from the difference between the strike price and closing price of the asset at the time of expiry. Let us take an example to understand risk reversal in a better way.


Example:

Suppose a trader buys a call option and sells a put option, both having the same strike price of ₹50, and the net premium to enter this position is ₹2. If the stock closes at ₹60 at the time of expiry, the trader will make a profit of ₹8 per share.


Find out using the above formula here:


Profit of the trader per share = (strike price - closing price of the stock) - A premium amount paid = (₹50- ₹60) - ₹2 =₹8 per share.


Assuming the trader has one contract of 100 shares, the profit will be ₹ 800 (8*100)


Break-even points of Risk reversal strategy:

The strategy has two break-even points as follows:

  • The break-even point for the call option contract is; strike price + amount of premium paid.

  • The break-even point for the put option contract is; the strike price - the amount of premium paid.

  • Considering the above example, the strike prices for the call and put options would be ₹48 and ₹52, respectively.


Conclusion:

Thus, we have seen the Risk Reversal option strategy in this article. It is a popular hedging technique used by only experienced traders to limit their downside risk while also expecting the advantage of potential price movements in the underlying asset. It is essential to note that options trading is complex and requires specific knowledge and skills. It should only be undertaken after proper training from experienced traders who can practically teach you about the risks involved.


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