Risk Reversal
Long call + short put (or vice versa)
What is Risk Reversal?
Risk Reversal A risk reversal is a defined-risk options structure that takes a directional view by simultaneously buying one option and selling another at different strikes. The most common form: **buy an OTM call, sell an OTM put** (bullish risk reversal). The bearish version is the mirror: buy an OTM put, sell an OTM call. Risk reversals are popular in FX markets and increasingly used in equity options for directional plays with low or zero net premium. The structure trades the volatility skew — you sell the side that's "expensive" relative to the side you buy. On equity options with put skew (puts more expensive than calls), bullish risk reversals are often opened for a credit rather than a debit. Mechanics of a bullish risk reversal: - Buy 1 OTM call (long upside exposure) - Sell 1 OTM put (short downside exposure) - Net cost: small debit, zero cost, or even a small credit depending on skew Risk profile: - **Max profit**: unlimited (long call has uncapped upside) - **Max loss**: large but defined to put strike (the short put has downside exposure to zero, minus credit received) - **Break-even**: depends on net cost. If opened for $0 cost, break-even = neutral (any directional move is pure profit until reaching either strike) The strategy expresses a "skew trade" — you're betting that the put-skew premium is overpricing crash risk relative to upside potential. If equity volatility skew is steep (deep negative skew), risk reversals are cheap (or credit). If skew is flat, risk reversals require a debit. Practical applications: - **Directional speculation with no upfront cost**: instead of paying for a long call, sell the OTM put to fund it. Eliminates the time-decay drag of pure long premium. - **Stock alternative for bullish investors**: 100 shares of long stock have ~100 delta; a zero-cost risk reversal might have ~80 delta with no upfront capital outlay (just margin requirement for the short put). - **Vol-skew trading**: when SPX skew is steep, the put is rich relative to the call. Selling that expensive put and buying the cheap call exploits the mispricing. - **Earnings plays**: pre-earnings risk reversals capture the directional thesis without paying for the IV expansion of long options. Risks to manage: - **Assignment on the short put**: a large move down past the short strike means assignment at the strike — equivalent to being long stock with a lower cost basis. Size the put strike to a price you'd be happy to own. - **Skew flip**: if vol skew flattens between entry and exit, the risk reversal value moves against you even without directional movement. - **Gap risk**: a 5%+ overnight gap below the short put strike creates uncovered downside exposure. Risk reversals are sophisticated structures. Most retail traders should master long calls and short puts independently before combining them into risk reversals.
Complete Definition
A risk reversal is a defined-risk options structure that takes a directional view by simultaneously buying one option and selling another at different strikes. The most common form: **buy an OTM call, sell an OTM put** (bullish risk reversal). The bearish version is the mirror: buy an OTM put, sell an OTM call. Risk reversals are popular in FX markets and increasingly used in equity options for directional plays with low or zero net premium. The structure trades the volatility skew — you sell the side that's "expensive" relative to the side you buy. On equity options with put skew (puts more expensive than calls), bullish risk reversals are often opened for a credit rather than a debit. Mechanics of a bullish risk reversal: - Buy 1 OTM call (long upside exposure) - Sell 1 OTM put (short downside exposure) - Net cost: small debit, zero cost, or even a small credit depending on skew Risk profile: - **Max profit**: unlimited (long call has uncapped upside) - **Max loss**: large but defined to put strike (the short put has downside exposure to zero, minus credit received) - **Break-even**: depends on net cost. If opened for $0 cost, break-even = neutral (any directional move is pure profit until reaching either strike) The strategy expresses a "skew trade" — you're betting that the put-skew premium is overpricing crash risk relative to upside potential. If equity volatility skew is steep (deep negative skew), risk reversals are cheap (or credit). If skew is flat, risk reversals require a debit. Practical applications: - **Directional speculation with no upfront cost**: instead of paying for a long call, sell the OTM put to fund it. Eliminates the time-decay drag of pure long premium. - **Stock alternative for bullish investors**: 100 shares of long stock have ~100 delta; a zero-cost risk reversal might have ~80 delta with no upfront capital outlay (just margin requirement for the short put). - **Vol-skew trading**: when SPX skew is steep, the put is rich relative to the call. Selling that expensive put and buying the cheap call exploits the mispricing. - **Earnings plays**: pre-earnings risk reversals capture the directional thesis without paying for the IV expansion of long options. Risks to manage: - **Assignment on the short put**: a large move down past the short strike means assignment at the strike — equivalent to being long stock with a lower cost basis. Size the put strike to a price you'd be happy to own. - **Skew flip**: if vol skew flattens between entry and exit, the risk reversal value moves against you even without directional movement. - **Gap risk**: a 5%+ overnight gap below the short put strike creates uncovered downside exposure. Risk reversals are sophisticated structures. Most retail traders should master long calls and short puts independently before combining them into risk reversals.
Example
AAPL at $185. Buy 1 $200 call for $1.20, sell 1 $175 put for $1.40. Net credit: $0.20 ($20 per contract). If AAPL closes above $200 at expiration, unlimited upside profit. If AAPL closes below $175, you're assigned 100 shares at $175 — effective cost basis $174.80 after credit.
Related Terms
Frequently Asked Questions
What is a risk reversal in options?
A risk reversal is a directional options structure that buys one option and sells another at different strikes. Most commonly: buy an OTM call, sell an OTM put (bullish version). The structure expresses a directional view while exploiting volatility skew — often opened for a credit rather than a debit on equity options.
How does a risk reversal differ from a long call?
A long call has limited downside (the premium paid). A risk reversal adds short-put exposure, eliminating the upfront cost but adding significant downside risk if the underlying crashes below the short put strike. Risk reversals have higher upside potential per dollar of capital but materially more risk.
When should I use a risk reversal?
When you have strong directional conviction, want to express that view without paying for long premium, and are willing to be assigned the stock at the short strike if you're wrong. Best used in steep-skew environments where the short option is structurally rich.
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