Veteran options trader Steve Smith breaks down the risk reversal.
Editor's note: To help investors profitably navigate the options market, Minyanville has launched "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers. Read the kick-off to the series here.
In previous articles in this series, we've looked at popular options trading strategies like calendar spreads, butterfly spreads, and condors, all of which use the simultaneous purchase and sale of puts or calls to create limited risk or partially hedged positions.
These traditional spreads allow you to reduce costs in exchange for capping gains. This week, we're getting more aggressive and drilling down into a strategy known as the risk reversal, which uses combinations of puts and calls to create a low-cost position that carries both unlimited risk and reward.
A risk reversal consists of being long (buying) an out-of-the-money call and being short (selling) an out-of-the money put, both with the same expiration date.
What makes the risk reversal different from most leveraged speculation or hedging strategies is that it aims to achieve a position with a very strong directional bias, but with a minimal capital outlay or possibly even a credit.
When constructing a risk-reversal position, the sale (purchase) of the put should offset the cost (credit) of the call.
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