What is a risk reversal option strategy?
How to trade a Risk Reversal Option Strategy
An option risk reversal strategy is a hedging strategy that involves the simultaneous selling (or writing) of an out-of-the-money call or put option while simultaneously buying the opposite option. The purpose of this strategy is to protect against unfavorable price movements in the underlying asset by limiting potential losses and potentially increasing gains.
To implement this strategy, the trader must sell an out-of-the-money put option and simultaneously buy an out-of-the-money call option with the same expiration date. The premium received from selling the put can then be used towards buying the call. If the cost of buying the call is higher than the premium received for selling the put, the trader will have a net debit. Conversely, if the trader sells a call and buys a put, they will generate a net credit.
It is important to note that commissions must also be considered when trading a risk reversal strategy, as they can affect the overall balance of the trade. Moreover, a risk reversal strategy can have different meanings in different contexts. In commodities trading, a risk reversal strategy involves selling a call and buying a put option to protect against unfavourable, downward price movements in the underlying asset. In foreign exchange trading (forex), a risk reversal strategy refers to the volatility of out-of-the-money call or put options, where a positive risk reversal means that the volatility of call options is higher than that of the corresponding put options, and a negative risk reversal means the opposite.
In summary, a risk reversal strategy involves selling an out-of-the-money put option and simultaneously buying an out-of-the-money call option to limit potential losses and potentially increase gains. The trader can have a net debit or net credit depending on the cost of the call and the premium received from selling the put. Commissions must also be considered when trading this strategy. However, it is important to note that the definition of risk reversal can vary depending on the context in which it is used.