A risk reversal combines selling an out-of-the-money put option with buying an out-of-the-money call option. The premium from the sold put pays for most or all of the bought call, creating a bullish position that costs little or nothing to enter.
The structure behaves somewhat like a futures position with a zone in the middle where nothing much happens. This article explains how it works, works through an example, compares it with futures, explains why skew matters, and sets out the risks, which are larger than the low entry cost suggests.
The structure
Sell an out-of-the-money put option below the current price.
Buy an out-of-the-money call option above the current price, same expiry.
If the price rises above the call strike, the bought call option gains. If the price falls below the put strike, the sold put loses. Between the two strikes, both options expire worthless at expiry, and the result is just the net premium.
The bearish version reverses it: buy a put, sell a call option. The same name is also used in currency and other markets to describe the price difference between equally out-of-the-money puts and call options, which reflects skew.
A worked example
Illustrative figures, with the index at 24,000, about two weeks to expiry under ordinary volatility. Prices are per unit.
Sell the 23,800 put option at about 88.
Buy the 24,200 call option at about 85.
Net: a credit of about 3.
At expiry, between 23,800 and 24,200: both expire worthless. Gain of 3.
At 24,500: the call option is worth 300. Gain of 303.
At 23,500: the sold put costs 300. Loss of 297.
Beyond the strikes, the position gains or loses about one point for every point the index moves. The risk below is open-ended in the same way as a long futures position, down to the index falling to zero in theory.
With a hypothetical lot of 50 units, a fall to 23,000 at expiry would mean a loss of about 797 × 50 = 39,850, before charges. The tiny entry credit says nothing about the size of the possible loss.
Compared with futures
A long futures position gains and loses one point for each point the index moves, from the entry price.
The risk reversal is similar outside the strikes but different in the middle:
The dead zone. Between 23,800 and 24,200, the risk reversal barely moves at expiry, while futures would gain or lose up to 200 points either way. If the index finishes at 24,150, futures gain 150; the risk reversal gains only 3.
Before expiry, the risk reversal behaves like a smaller directional position, with a delta well below 1, rising as the index moves towards either strike.
Margin. The sold put requires margin, broadly comparable in kind to a futures position. The bought call option is paid in full.
Volatility exposure. Futures have none. A risk reversal is affected by changes in implied volatility on both legs, and particularly by skew.
So the risk reversal suits someone who is bullish but not expecting a small move, and who wants a structure that ignores modest noise around the current price.
Managing before expiry. If the index rises well above the call strike early, the bought call option has gained and the sold put has lost most of its value; closing the put leg cheaply and keeping the call option can lock in much of the gain while removing the downside. If the index falls towards the put strike, decide in advance whether you will close, roll or accept the long exposure.
Why skew matters
In Indian index options, out-of-the-money puts often carry higher implied volatility than equally distant call options. This is skew, reflecting demand for downside protection.
Skew helps the bullish risk reversal: the put you sell is relatively expensive and the call option you buy relatively cheap, which is why the structure can often be entered at near zero cost or a small credit.
But skew also reflects something real: the market tends to fall faster than it rises, and sharp falls are what put buyers pay to protect against. Selling that protection means accepting exactly the risk others are paying to avoid.
Changes in skew affect the position before expiry. In a sell-off, put implied volatility often rises sharply, so the sold put loses value faster than the index move alone would suggest.
When it fits, and the risks
Fits: a clear bullish view on a larger move, a willingness to take the downside risk of a long position below the put strike, and enough capital and margin to hold through adverse moves.
A related use: an investor willing to buy the underlying at the put strike may view the sold put as a way to enter at a lower price, financing upside exposure through the bought call option. That is a combination of selling puts to buy shares and buying upside.
Main risk: a sharp fall. The loss below the put strike is open-ended and can be large on gaps. Adding a further-out bought put turns it into a defined-risk structure at some cost; that version is closer to a collar-like shape.
Other risks: margin increases in volatile markets, skew changes, liquidity in out-of-the-money strikes, and physical settlement for stock options held to expiry.
Size it like a futures position, not like a near-free trade. The low entry cost is the most misleading feature of the structure.
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Frequently Asked Questions
What is a risk reversal in options?
A structure that sells an out-of-the-money put option and buys an out-of-the-money call option with the same expiry, creating a bullish position at little or no net cost.
Is a risk reversal the same as buying futures?
It behaves similarly beyond the strikes, but has a zone between the strikes where little happens at expiry, and it is affected by implied volatility and skew.
What is the maximum loss on a risk reversal?
Below the put strike the loss is open-ended, like a long futures position, and can be large on a sharp fall or gap.
Why can a risk reversal be entered for a credit?
Because out-of-the-money puts often trade at higher implied volatility than equally distant call options, due to skew.
How can the downside of a risk reversal be limited?
By buying a further out-of-the-money put, turning it into a defined-risk structure at some extra cost.
Related Reading
- The bias behind holding losing positions
- How skew shapes the two premiums
- Futures and options compared
- Selling puts to enter lower
- Adding protection to a position
- Margin on sold options
Disclaimer: TheFinBaba provides educational content only - this is not investment advice. Trading involves risk of loss.
