What is Risk Reversal?
Risk Reversal, when trading in the futures markets, is used as a hedge strategy that limits upside potential while simultaneously limiting downside exposure of an outright futures position by selling a call option and buying a put option at the same time. This strategy limits the upside potential to the strike of the call option sold, while limiting downside exposure to the strike of the put option purchased. Typically, you will try to bring in enough or more premium from the short call option to fund your long put options.
When to use Risk Reversal strategy when trading futures
This hedge strategy would ideally be used when a trader is long a futures contract and currently has a profit from their position. You can use this strategy to then lock in your max profit (strike price of the short call) while at the same time using your put option similar to how you would use a “stop loss” order, but without actually having to exit the trade. The strike price that you buy on your put option is now your max risk level. In this situation, a trader would most likely lock in a break even or possibly even a profit on their overall position.
On the contrary, this strategy can also be used when the original futures position is showing a loss. The strategy is the same, but the outcome is most likely going to be limiting downside risk at a loss, instead of locking in a break-even/profit.
Short Risk Reversal vs. Long Risk Reversal Strategy
A futures trader will implement a “Long Risk Reversal” strategy when they are short the outright futures position. A “Short Risk Reversal” strategy will be used when a futures trader has a long outright futures position.
Examples of Risk Reversal Strategy
Short Risk Reversal Example
Short Risk Reversal: A trader buys 1 E-mini S&P contracts at 2400-00. The market has now traded up to 2450-00. The trader then sells the 2500 Call option to bring in a premium of 30 points, while simultaneously buying the 2425 Put option for 20 points. This will bring in a total credit of 10 points. If the futures market goes to 2510 by expiration, the traders profit is maxed out at 2500, even though the market is at 2510. If the market goes to 2400 by expiration, the trader has limited his risk to 2425 which locks in a profit of 25 points, on top of bringing in a credit of 10 points from the option premium.
Long Risk Reversal Example
Long Risk Reversal: This will be the same idea as the “Short Risk Reversal” with the exact opposite parameters. The trader will be short the futures (instead of long) and use Selling a Put to bring in premium while buying the Call to limit the risk on an adverse move in the futures.