what is a risk reversal 
a risk reversal is a hedging strategy that protects a long or short position by using put and call options this strategy protects against unfavorable price movements in the underlying position but limits the profits that can be made on that position if an investor is long a stock they could create a short risk reversal to hedge their position by buying a put option and selling a call option in foreign exchange fx trading risk reversal is the difference in implied volatility between similar call and put options which conveys market information used to make trading decisions understanding risk reversalrisk reversals also known as protective collars have the purpose of protecting or hedging an underlying position using options one option is bought and another is written the bought option requires the trader to pay a premium while the written option produces premium income for the trader this income reduces the cost of the trade or even produces a credit while the written option reduces the cost of the trade or produces a credit it also limits the profit that can be made on the underlying position another protective strategy that uses three option contracts to provide a range around the underlying security is the fence strategy the objective of a risk reversal is to capitalize on potential price movements in an underlying asset while mitigating the upfront cost through the premium received from the options sold traders often use risk reversals when they have a directional bias on the underlying asset but want a way to creatively offset the expenses associated with buying options it s important to note that risk reversals themselves carry risk if the underlying asset does not move in the way you think it will you can lose money risk reversal mechanicsif an investor is short an underlying asset the investor hedges the position with a long risk reversal by purchasing a call option and writing a put option on the underlying instrument if the price of the underlying asset rises the call option will become more valuable offsetting the loss on the short position if the price drops the trader will profit on their short position in the underlying but only down to the strike price of the written put if an investor is long an underlying instrument the investor shorts a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying instrument if the price of the underlying drops the put option will increase in value offsetting the loss in the underlying if the price of the underlying rises the underlying position will increase in value but only up to the strike price of the written call risk reversal and foreign exchange optionsa risk reversal in forex trading refers to the difference between the implied volatility of out of the money otm calls and otm puts the greater the demand for an options contract the greater its volatility and its price a positive risk reversal means the volatility of calls is greater than the volatility of similar puts which implies more market participants are betting on a rise in the currency than on a drop and vice versa if the risk reversal is negative thus risk reversals can be used to gauge positions in the fx market and convey information to make trading decisions ratio risk reversalsratio risk reversals are a variation of the traditional risk reversal strategy that involves an uneven number of bought and sold options in a ratio risk reversal an investor might buy a greater number of options calls or puts than the number of options they sell this creates an asymmetrical exposure to market movements allowing the trader to capitalize on their directional bias while potentially improving the cost structure of the strategy you often choose the difference in the ratio based on your risk tolerance for instance in a bullish ratio risk reversal you might buy two call options for every one put option sold this implies a stronger conviction in an upward price movement while still providing a downside protection the ultimate goal here is to leverage the potential gains from a favorable market direction while adjusting the position to align with your risk preference note that the name of this financial strategy is risk reversal not risk elimination it is still possible to lose money in a risk reversal position calendar risk reversalsanother variation of a traditional risk reversal is the calendar risk reversal in this strategy an investor simultaneously buys and sells options with different expiration dates while maintaining a specific ratio this approach allows the trader to benefit from both the directional movement of the underlying asset and the time decay of the shorter term option creating a dynamic risk reward profile in a bullish calendar risk reversal an investor might buy a longer term call option and sell a shorter term call option the key advantage here is the ability to capitalize on the different rates of time decay the longer term option serves as a way to maintain exposure to the underlying asset s price movements while the shorter term option helps offset the cost through premium received from the sale and takes advantage of quicker time decay limitations of risk reversalsone significant limitation to risk reversals is the potential for losses if the market does not move as anticipated despite the name this investment strategy increases risk should markets play out not as expected another limitation is the impact of transaction costs and bid ask spreads when you simultaneously buy and sell options you ll incur higher transaction costs this is especially true if you re trying to buy options for illiquid securities additionally the bid ask spreads can widen further eating into potential profits the effectiveness of risk reversals is also influenced by changes in implied volatility if implied volatility increases the cost of options generally rises meaning you may get a lower reward for the same amount of risk last risk reversals may not be suitable for all market conditions or trading objectives they are designed for investors who have a specific view on an underlying asset and are willing to take a stance on which way the market will move for that good in more uncertain or volatile markets alternative strategies or risk management techniques might be a better idea real world example of a risk reversalsay sean is long general electric company ge at 11 and wants to hedge his position he could initiate a short risk reversal let s assume the stock currently trades near 11 sean could buy a 10 put option and sell a 12 50 call option since the call option is otm the premium received will be less than the premium paid for the put option thus the trade will result in a debit under this scenario sean is protected against any price moves below 10 because below this the put option will offset further losses in the underlying if the stock price rises sean only profits on the stock position up to 12 50 at which point the written call will offset any further gains in the general electric s share price 