Risk-Reversal

DESCRIPTION: A call spread is a bullish stock-replacement strategy that gives up some upside potential while outperforming stock at the margin on the downside. To construct a risk-reversal, one typically buys an upside call option and sells a downside put to pay for it. Both options use the same expiration date. A risk-reversal can be structured to generate a debt or credit, depending on the strike prices chosen on the two options. It gets this name because when the share price rises, the investor has the option of getting long the stock. If the share price falls, they must get long the stock.

MOTIVATION: The investor who buys a risk-reversal seeks to capture a profit from an increase in the price of the underlying asset without putting up cash right away. The advantage of this structure vis–à–vis buying stock outright is that one can get exposure to a stock’s bullish move right away, while getting an opportunity to buy it at below the current market price, should it fall before the anticipated bull move.

OUTLOOK: The investor who buys a risk-reversal believes the share price could takeoff right away, but seen issues that could temporarily knock the share price down in the short term. Risk-reversals are appropriate for an investor who wants to buy a stock but wants a little price protection just in case they are a little early. These investors are usually looking for a sharp move higher, but are uncertain when that move will happen. This structure allows the investor to manage or even profit from time decay, as they wait for the anticipated move to happen. Given the downside risk, the investor usually has conviction behind an investment thesis.

PROFIT/LOSS: Maximum (Asset Price – Call Strike, 0) or Minimum (Put Strike – Asset Price)- Net Premium Paid
The amount one earns at expiration depends on which direction the share price moved. If the share price goes higher, the profit is equal to the price of the underlying asset less the strike price of the call or zero less the initial premium paid. If the share price goes lower, the loss is equal to the strike price of the put less the price of the underlying asset less the initial premium paid. If the share price is between the two strikes, the gain or loss is equal to the credit or debit paid when the trade was initiated.

BREAKEVEN: Asset Price – Call Strike + Premium Paid
Put Strike – Asset Price + Premium Paid

There are two breakeven levels on a risk reversal, one for a bullish scenario and one for a bearish scenario. If the share price rises, the breakeven is the asset price less the call strike price less the debit paid. If the share price falls, the breakeven is equal to the put strike less the asset price plus the premium paid.

MAXIMUM GAIN: Unlimited
A risk-reversal is a stock replacement strategy. Since a share price can rise without limit, so can a risk reversal.

MAXIMUM LOSS: Put Strike + Premium Paid
The price of a stock can go to zero. In this scenario a put seller will get assigned stock at the strike price of the put. Therefore their maximum loss is equal to the put strike plus the premium paid when the trade was initiated.

VOLATILITY: Volatility is a weak driver of profitability. Since the expiration of the two options are the same, any you are long one option and short another, changes in implied volatility has little effect on the price of a risk-reversal. Skew is a factor however. As skew increases the price of risk reversal falls. Direction is what matters with a risk-reversal. If a realized upside move manifests, the investor will profit. If a realized downside move manifests, the investor loses.

TIME DECAY: Time decay can work for or against the investor depending on the strike prices choses. If the position is structured with a credit, time decay will work for the investor. If the position is structured as a debit, time decay will work against the investor.

ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. However, puts are usually not assigned early unless the option is way in the money.

EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Since options have a limited life, there is a risk that the risk-reversal will expire worthless. A secondary risk is what happens with respect to assignment at expiration. If the share price closes at or near the put strike, the investor may or may not be assigned. They will not know if you have been assigned until your broker informs you which they will do the day following expiration.