Risk Reversal

Risk reversals options


    During the first month of the coronavirus crisis, the stock market fell from record highs with unprecedented speed.

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    Meanwhile, the subsequent rally has been just as befuddling to many. One strategy to consider is letting the range work to our advantage by buying out-of-the-money calls while simultaneously risk reversals options out-of-the-money puts.

    risk reversals options

    Owning exposure on such a breakout is attractive. We want to buy the next dip. This strategy is called a risk reversal and many investors execute how to make 2020r quickly option spread strategy in equal contract amounts.

    risk reversals options

    However, due to the big difference in strike prices, this would result in dramatically unequal notional exposures.

    Therefore, we will construct this spread using equal notional amounts. It is also initially a positive theta position, with the time value decaying each day in our favour.

    This means that all other variables being constant the position would carry positively with the position holder if the XIU remains unchanged over the next month. Table 2: Option Greeks for spread position on July 1, Source: Bloomberg Here are the payoff profiles at various points in time.

    If we were to execute this strategy using equal contract amounts 50 of eachthe credit earned would be much less.

    risk reversals options

    The next time you execute a long-dated option strategy with varying strike prices, think about the fact that the notional values of the underlying are very different. Increasing the number of contracts so that the notional amounts are equal will change the nature of the option spread, while risking the same total number of dollars.

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    The risk reversal strategy shares many of the characteristics of investing, with risk reversals options positive carry and a better risk profile if a market correction ensues. Note that, to implement this strategy as a retail investor, you will need to execute it in a margin account that is approved for selling puts.

    risk reversals options

    The broker will require margin as collateral for the short puts. While this strategy is a little more advanced, it may be a good fit for investors who are looking to create a better payoff profile than a simple long equity position can offer.

    risk reversals options

    Disclaimer: The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security.

    As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option risk reversals options.