Risk Reversal
Sell an OTM put and buy an OTM call. A bullish synthetic-like position that uses put premium to finance call buying.
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What is a Risk Reversal?
A risk reversal is a two-leg bullish strategy where you sell an out-of-the-money put and use that premium to buy an out-of-the-money call. It is similar to a synthetic long stock, but with a gap between the strikes. That gap creates a neutral zone where neither option has value.
The idea is simple: you are bullish and want call exposure, but you do not want to pay full price. So you sell a put to finance the call. If the stock goes up, the call makes money. If the stock goes down, the put costs you money. In between, both options expire worthless and you walk away roughly flat.
Risk reversals are extremely popular in forex and commodity markets. In equities, they are used by traders who have strong directional conviction and want leverage without a big upfront cost.
How to Set It Up
- Sell 1 OTM put below the current price
- Buy 1 OTM call above the current price
- Same expiration for both
- Strike selection: The put and call are typically equidistant from the current price, but you can adjust. Selling a put closer to the money generates more premium to buy a better call.
- Expiration: 30-90 days. Shorter durations decay the short put faster but give less time for the call to work.
- Net cost: Can be a small debit, small credit, or zero depending on strikes and volatility skew.
If put skew is steep (as it often is in equities), you might collect more from the put than you pay for the call, entering for a net credit.
When to Use This Strategy
Use a risk reversal when:
- You are strongly bullish
- You want leveraged upside without paying full price for a call
- You are willing to accept put-like downside risk
- Implied volatility skew makes puts expensive and calls cheap
- You want to express a view cheaply or for zero cost
The risk reversal is essentially saying: "I am so bullish that I will sell insurance on the downside to pay for my upside ticket." It is a confident trade.
Example Trade
Stock XYZ is trading at $100. You are bullish over the next two months.
- Sell 1 XYZ $95 put for $2.50
- Buy 1 XYZ $105 call for $2.00
- Net credit: $2.50 - $2.00 = $0.50 ($50 collected)
If XYZ rallies to $115: The call is worth $10 (+$1,000). The put expires worthless. Total profit: $1,000 + $50 = $1,050. Great outcome.
If XYZ stays at $100: Both options expire worthless. You keep the $50 credit. No harm done.
If XYZ drops to $90: The put is worth $5 (-$500). The call is worthless. Loss: $500 - $50 = $450.
If XYZ drops to $80: The put costs $15 (-$1,500). Call is worthless. Loss: $1,500 - $50 = $1,450. The downside risk is real and significant.
Risk and Reward
- Max profit: Unlimited. The long call has no cap. As the stock rises above the call strike, you profit dollar-for-dollar.
- Max loss: (Put strike - net credit) x 100 if the stock drops to zero. In our example: ($95 - $0.50) x 100 = $9,450. This is the same risk as owning 100 shares from $95.
- Breakeven: Call strike +/- net premium. With a $0.50 credit: $105 - $0.50 = $104.50 on the upside. On the downside, you are profitable as long as the put is not tested.
The payoff is similar to owning stock but with a dead zone in the middle where you make nothing (except any net credit).
Tips and Common Mistakes
- Understand that selling the put is like being willing to buy the stock. If the stock drops to your put strike, you may be assigned. Make sure you are comfortable at that price.
- Volatility skew is your friend. In equities, puts are usually more expensive than calls (skew). This means you collect more than you pay, often entering for a credit.
- Do not ignore the downside. The unlimited-profit upside is exciting, but the loss on the short put can be substantial. This is an undefined-risk trade.
- Great for stocks you want to own cheaper. If you would buy XYZ at $95 anyway, the short put is just a bid to buy. The call is a free bonus if the stock rallies.
- Manage the short put actively. If the stock approaches the put strike, decide whether to close, roll, or accept assignment.
Related Strategies
- Synthetic Long Stock — same concept but both options at the same strike
- Long Call — just the upside leg, no downside risk
- Short Put — just the put-selling component
- Collar — risk reversal applied over stock (buy put, sell call)
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