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Risk Reversal - An Option Trading Strategy


Risk Reversal - An Option Trading Strategy

Today, we shall learn about the risk reversal options strategy in this article. As the name suggests, risk reversal is used for reversing the risk on the position. It is a multi-leg option strategy in which the risk is defined, and the profit potential is limited. It is a complex strategy and requires a lot of experience to implement. Those with high analytical skills and good prediction power can use this strategy to limit their downside risk and allow themselves to profit from the price movement of the underlying stock.


The risk reversal strategy is often used by traders who are bullish on their position but want to protect their investment against the potential loss if the market does not work in their favor.


A market scenario of risk reversal:

Traders use this strategy when they expect moderate or high volatility in the price of an underlying asset. When the market is experiencing high volatility, the chances to profit become high. Traders use this to create a risk-free profit for their position. The reversal strategy is mainly known to limit the risk and protect the long option contract from unexpected movement.


Traders use this strategy when they expect moderate or high volatility in the price of an underlying asset. When the market is experiencing high volatility, the chances to profit become high. Traders use this to create a risk-free profit for their position. The reversal strategy is mainly known to limit the risk and protect the long option contract from unexpected movement.


How to set up a risk reversal strategy?

Risk reversals are created by buying and selling an option contract having the same underlying stock and the expiry dates. If a trader is long on a specific stock, he will sell a short call option at the purchase price of that stock and will buy another long put option at the same strike price to create a reversal. This strategy is much similar to the collar strategy.


The long position of the reversal strategy offers protection against uncertain market movements to traders. In contrast, the short legs of the strategy offset the buying cost of another long position, limiting the profit.


How to enter the risk reversal strategy?

To enter the risk reversal strategy, traders need to buy and sell the option of the same underlying stock, having the same strike price and expiry. Generally, the trader buys or sells the at the purchase price or might be higher. If a trader holds long stock, then he has to place a buy-to-open order for a long-put option contract. In the same way, if the trader is short on the stock, he reverses the position by purchasing a long call option and selling a short put option contract.


The strategy's main purpose is to collect some credit at the initial stage. This credit is guaranteed; no matter what happens to your contracts, you keep this amount as your guaranteed profit.


Highest profit on the strategy?

As we said, the profit is limited in this strategy; it is limited to the price difference between the strike prices of call and put option contracts minus the net premium paid for all the options.


What are the breakeven points of the risk reversal strategy?

The breakeven point of the risk reversal strategy depends on whether the strategy was opened for debit or credit. If a trader has entered the strategy for credit, the breakeven point would be the put option's strike price - premium received.


Let us take an example:

Suppose a trader has a stock that he bought at ₹100. Then to enter the reversal strategy trader would open a buy-to-open a ₹100 put and a sell-to-open a ₹100, both having the same expiry. This position will only profit if the credit received by selling is more than the premium paid for buying the contract.


The diagram of the reversal strategy is a straight horizontal line showing the credit the trader received.


In case the price of the asset appreciates since the trader initiated the position, in such cases, risk reversal can be opened at a price above the purchase price of the stock.


Conclusion:

The Risk Reversal option strategy is useful for investors who want to protect themselves from downside risk while still allowing for profit if the market moves in their favor.


As with any options trading strategy, investors should consider risk tolerance and market expectations before entering a Risk Reversal option strategy.


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