Stock risk reversal using call options and put options

Obtain huge potential returns at a small premium-this is the inherent appeal of risk reversal strategies. Although risk reversal strategies are widely used in the foreign exchange and commodity options markets, in terms of stock options, they are often mainly used by institutional traders and seldom used by retail investors.

For options newbies, risk reversal strategies may seem a bit daunting, but for experienced investors familiar with basic put and call options, they can be a very useful “choice”.

What is risk reversal?

The most basic risk reversal strategy involves selling (or selling) out-of-the-money (OTM) put options and buying OTM call options at the same time. This is a combination of a short bearish position and a long bullish position.

Since selling put options will cause option traders to receive a certain amount of premium, the premium income can be used to buy call options. If the cost of buying a call option is greater than the premium received from selling a put option, the strategy will involve net borrowing.

Conversely, if the premium for selling the put option is greater than the cost of the call option, the strategy generates net credit. If the premium received for the put option is equal to the payout of the call option, it will be a no-cost or zero-cost transaction. Of course, commissions must also be considered, but in the following example, we will ignore them to keep it simple.

It is called risk reversal because it reverses the “volatility skew” risk that option traders usually face. In very simple terms, this is what it means. OTM put options generally have higher implied volatility (and therefore more expensive) than OTM call options because of greater demand for protective put options to hedge long stock positions. Since risk reversal strategies usually require selling options with higher implied volatility and buying options with lower implied volatility, this skew risk is reversed.

Risk reversal application

Risk reversal can be used for speculation or hedging. When used for speculation, risk reversal strategies can be used to simulate synthetic long or short positions. When used for hedging, the risk reversal strategy is used to hedge the risk of an existing long or short position.

The two basic changes in risk reversal strategies used for speculation are:

  • Write OTM put option + buy OTM call option: This is equivalent to a synthetic long position, because the risk-reward profile is similar to a long stock position. This strategy is called a bullish risk reversal. If the stock rises sharply, the strategy is profitable, and if the stock price drops sharply, it is unprofitable.
  • Write OTM call option + buy OTM put option: This is equivalent to a synthetic short position, because the risk-reward profile is similar to a short stock position. If the stock price falls sharply, this bearish risk reversal strategy is profitable, and if the stock price rises sharply, it is unprofitable.
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The two basic changes to the risk reversal strategy used for hedging are:

  • Write OTM call option + buy OTM put option: This is used to hedge an existing long position and is also called a “collar”. A specific application of this strategy is a “cost-free collar”, which enables investors to hedge long positions without incurring any upfront premium costs.
  • Write OTM put option + buy OTM call option: This is used to hedge an existing short position, and like the previous example, it can be designed at zero cost.

Risk reversal example

Let us use Microsoft to illustrate the design of speculative risk reversal strategies and hedging long positions.

On June 10, 2014, Microsoft closed at $41.11. At that time, the last quote of MSFT’s October 42 USD call option was 1.27 USD/1.32 USD, with an implied volatility of 18.5%. MSFT October 40 USD put options are quoted at 1.41 USD/1.46 USD, with an implied volatility of 18.8%.

Speculative trading (synthetic long position or bullish risk reversal)

  • Write 5 times MSFT October $40 Put option Buy 5 times MSFT at the price of 1.41 USD October 42 USD telephone 1.32 USD.
  • Net credit (excluding commission) = US$0.09 x 5 spreads = US$0.45.

Please note the following:

  • MSFT’s last transaction price was $41.11, the $42 call option was 89 cents out of the money, and the $40 put option was $1.11 OTM.
  • In all cases, the bid-ask spread must be considered. When writing an option (put or call), the option author will receive the bid price, but when buying the option, the buyer must pay the asking price.
  • It is also possible to use different option expiration and strike prices. For example, traders can choose June put options and call options instead of October options if they believe that the stock may change significantly within one and a half weeks after the option expires. However, although the June 42 USD call option is much cheaper than the October 42 USD call option (0.11 USD to 1.32 USD), the premium of the June 40 USD put option is also much lower than the October 40 USD put premium (0.10 USD). USD to 1.41 USD).

What is the risk-reward return of this strategy? Shortly before the expiration of the rights on October 18, 2014, there are three potential scenarios for the strike price:

  1. MSFT transaction price is higher than $42: This is the best case, because the transaction is equivalent to a synthetic long position. In this case, the $40 exercise right put option will be worthless, and the $42 call option will have a positive value (equal to the current stock price minus $42). Therefore, if Microsoft soars to $45 by October 18th, then the $42 call option is worth at least $3. So the total profit is $1,500 (3 x 100 x 5 bullish contracts).
  2. MSFT’s transaction price is between US$40 and US$42: In this case, both the $40 put option and the $42 call option will expire worthless. This hardly affects the trader’s wallet, because a marginal credit of 9 cents was received at the beginning of the transaction.
  3. MSFT is trading at less than $40: In this case, the $42 call option will expire worthlessly, but because the trader holds a short position in the $40 put option, the strategy will produce a loss equal to the difference between $40 and the current stock price . Therefore, if Microsoft fell to $35 by October 18, the trading loss would be equal to $5 per share, or a total loss of $2,500 (5 x 100 x 5 put contracts).

Hedging transaction

Suppose an investor already owns 500 shares of MSFT stock and wants to hedge downside risks at the lowest cost. (This is a combination of guaranteed call options + protective put options).

  • Write 5 times MSFT October $42 telephone 1.27 USD, buy 5 times MSFT October 40 USD Put option 1.46 USD.
  • Net debit (excluding commission) = 0.19 USD x 5 spreads = 0.95 USD.

What is the risk-reward return of this strategy? Shortly before the expiration of the rights on October 18, 2014, there are three potential scenarios for the strike price:

  1. MSFT transaction price is higher than $42: In this case, the stock will be redeemed at the call option strike price of $42.
  2. MSFT’s transaction price is between US$40 and US$42: In this case, both the $40 put option and the $42 call option will expire worthless. The only loss the investor suffered was the hedging transaction cost of US$95 (US$0.19 x 100 x 5 contracts).
  3. MSFT is trading at less than $40: Here, the $42 call option will expire worthless, but the $40 put position will be profitable, offsetting the loss of the long stock position.

Why would investors use such a strategy? Because it can effectively hedge long positions that investors want to keep at the lowest or zero cost. In this particular example, investors may think that MSFT has little upside potential in the short term, but the downside risks are high. Therefore, they may be willing to sacrifice any upside above $42 in exchange for downside protection for share prices below $40.

When should a risk reversal strategy be used?

In certain specific situations, risk reversal strategies can be best used:

  • When you really like a stock but need some leverage: If you really like a stock, if (a) you don’t have the funds to buy it directly, or (b) the stock looks a bit expensive and out of your buying range, then it’s wise to write an OTM put option on it The scope of the strategy. In this case, selling OTM put options will earn you some premium income, but you can “double” your bullish view by using part of the put option proceeds to buy OTM call options.
  • In the early stages of the bull market: Quality stocks can soar in the early stages of a bull market. At this time, the risk on the short bearish leg assigned to the bullish risk reversal strategy will be reduced, and if the underlying stock soars, the OTM call option may bring a huge price increase.
  • Before spin-offs and other events (such as upcoming stock splits): Investor enthusiasm in the days before the split or stock split usually provides solid downside support and leads to a significant price increase. This is an ideal environment for risk reversal strategies.
  • When blue chip stocks suddenly plummet (especially during a strong bull market): During a strong bull market, blue chips temporarily out of favor due to lack of earnings or some other adverse events are unlikely to stay in the penalty box for a long time. If the stock rebounds during this period, implementing a risk reversal strategy with a mid-term maturity (for example, six months) may bring substantial returns.

The pros and cons of risk reversal

The advantages of risk reversal strategies are as follows:

  • low cost: Risk reversal strategies can be implemented at little or even free cost.
  • Favorable risk reward: Although not without risk, these strategies can be designed to have unlimited potential profits and low risk.
  • Suitable for many occasions: Risk reversal can be used in various trading situations and scenarios.

So what are the disadvantages?

  • Margin requirements can be onerous: Margin requirements on the short side of risk reversal can be considerable.
  • Significant risks of short legs: The bearish bearish leg with bullish risk reversal and the bearish bullish leg with bearish risk reversal are very risky and may exceed the risk tolerance of ordinary investors.
  • double:” Speculative risk reversal is equivalent to doubling the bet on a bullish or bearish position. If the reason for the transaction proves to be incorrect, it is risky.

Bottom line

Very favorable risk-reward return and low-cost risk reversal strategies enable them to be effectively used in a wide range of trading scenarios.

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