Risk Reversal

Legend
Kc = Strike for out of the money (OTM) call option
Kp = Strike for out of the money (OTM) put option

In this pay-off diagram, Kp represents the strike for selling the OTM put option while Kc represents the strike for the long call option. The cost of a symmetrical OTM put option and OTM call option can differ depending on a variety of factors including the level of interest rates and market sentiment.

When the price of the stock remains between Kp and Kc at expiry, the payoff would be the difference between the premium received from selling the put option and the premium paid for buying the call option. If the price of the stock rises above Kc, then the pay-off would be similar to being long from the price of Kc + the net premium received if any. Conversely, if the stock falls below Kp, the pay-off would be similar to being long from Kp + the net premium received if any.

Let’s say Apple is trading at $170 now. A trader wishes to buy 100 Apple shares at the price of $160. Instead of placing a limit buy, he sells an OTM put option at strike 160 expiring in 1 month for a premium of $3. Concerned that Apple might rally continuously and not fall below the price of $160, he simultaneously bought an OTM call option at strike 180 for $1.60 with the same expiry date. The cost of the call option ($1.60) was completely offset by the premium received from the sale of the put option. The trader receives a net premium of $1.40 per share.

Scenario 1: Apple goes below $160
The investor would be assigned Apple shares at $160. Breakeven point = $160 – $1.40 = $158.60.

Scenario 2: Apple goes above $180
The investor would not be assigned any Apple shares. Since he is long a call option at strike 180, the trader is able to exercise this call option to buy Apple shares at $180. Breakeven point = $180 - $1.40 = $178.60.

Scenario 3: Apple trades between $160 and $180The investor would not be assigned any Apple shares nor will he be buying Apple shares through an option exercise. Premium received from option strategy = $1.40/share

Summary
The risk reversal is a useful strategy in an investor’s toolkit. This is especially so for stock investors who wish to accumulate shares by selling puts while still retaining upside potential if the stock rallies continuously without falling below the put strike. Investors who wish to retain this upside can do so by buying an out of the money call option using some proceeds from the put option sale. However, if investors feel confident that the stock will trade sideways, then they can save some premium by utilizing the cash secured puts strategy (only sell the put option).