As the name suggests, Risk Reversal is a hedging strategy for the reversal of risk using options. Risk Reversal is used to hedge a position, or protect a position without any additional cash outlay. In other words, what one is essentially doing is insuring position against catastrophic loss, while positioning oneself for potential gains.
In a Risk Reversal, one would use the premium received from the sale of a call or put option to finance the purchase of the opposite option for a minimal or no outlay of additional funds. Let’s see how this words with a specific example:
Verizon (VZ) closed at $35.84 on March 18, 2011. The 2013 (LEAPS) out-of-the-money $30 strike puts are listed at $3.10 to sell. If you sell the $30 LEAPS puts, you will receive a premium of $3.10. By selling this put, you are obligating yourself to buy the stock at the $30 strike. This represents a risk below $26.90. In other words, VZ would have to decline to below $26.90 before you start losing money on this position. Technically, VZ can decline to 0, but you are selling the $30 strike because you are feeling bullish on VZ, and expect its price to rise in the next two years. When you sell a put, your maximum profit potential is the premium received, in this case $3.10.
Since you are bullish on VZ, you would simultaneously buy an out-of-the-money LEAP call option at the $37 strike for $2.91. This position would be paid for by the premium received for the puts, and would also position you to profit in any upside of VZ. Your total Risk Reversal position in this case would create a CREDIT of $0.19 per share, and would position you for any upside in the stock. Buy OTM Call + Sell OTM Put
Suppose you are bearish on a stock, say, Microsoft (MSFT). You might create a Risk Reversal that takes the opposite stance, to wit: buy an out-of-the-money put (that would protect the downside) and sell and out-of-the-money call.
Buy OTM Put + Sell OTM Call
MSFT closed at $24.80 on March 18, 2011. By buying an out-of-the-money LEAPS $22.5 put, you would spend $2.95 per share ($295 per 100-share contract). You are thus protecting any potential decline in the stock below $22.50 between now and 2013. In order to finance this insurance, you would sell a call, say the 2013 LEAPS $25 strike call for $3.25 ($325 per contract), thus creating a CREDIT of $0.30 ($30 per contract). You have just positioned yourself to profit should the stock rally and protect yourself should the stock plummet. And you did this for a CREDIT. Can’t do better than that on your house!
Here is another possibility using the QQQQ (closed at $54.45 on 3/18/11)
In order to protect from any further declines in the stock, which is a proxy for the NASDAQ, you might buy an out-of-the-money put and sell an out-of-the-money call.The 2012 $52 strike put costs $4.15 to buy. The 2012 $55 strike call pays $4.48 to sell. Net effect: CREDIT $0.33 per share, or $33 per contract.
The effect of creating this Risk Reversal is to protect from any further declines in the Q’s, and being paid for such protection. As long as the Q’s remain below $55 by 2012, the call premium of $4.48 you received will erode because of the time value, and the puts that you purchased will increase in value as the Q’s continue to decline. If, however, you expect the Q’s to rally from now until January 2012, you may also use some of the CREDIT you received to purchase out-of-the-money calls to participate in such rally.
If one were to buy insurance to protect one’s home or car, one would have to spend some money for that insurance. The same goes for stock. But unlike the cost of insurance for a home or car, in a Risk Reversal one might also profit should the asset appreciate significantly in price.