# Risk Reversal Strategy: Hedging With Options Explained

## What Is a Risk Reversal?

Risk reversals, often termed protective collars, [hedge](https://www.investopedia.com/terms/h/hedge.asp) long or short positions by combining [put](https://www.investopedia.com/terms/p/put.asp) and [call](https://www.investopedia.com/terms/c/call.asp) options. This strategy shields against adverse price shifts in underlying assets, albeit at the cost of capping potential profits. For instance, [investor](https://www.investopedia.com/terms/i/investor.asp)s holding long positions might buy a put option and sell a call option to craft a short risk reversal, thereby managing risk without relinquishing their stock holdings.

In [foreign exchange](https://www.investopedia.com/ask/answers/08/what-is-foreign-exchange.asp) (FX) trading, risk reversal is the difference in [implied volatility](https://www.investopedia.com/terms/i/iv.asp) between similar call and put options, which conveys market information used to make trading decisions. 

### Key Takeaways

*   A risk reversal strategy involves using options to hedge against unfavorable price movements while limiting potential profits.
*   This strategy is comprised of buying a put option and selling a call option, or vice versa, depending on the position being hedged.  
    
*   In foreign exchange trading, risk reversals reflect the difference in implied volatility between calls and puts, indicating market sentiment on currency movements.  
    
*   Variations of risk reversals, like ratio and calendar risk reversals, allow traders to adjust exposure and cost structure based on market conviction and conditions.  
    
*   Risk reversals carry potential risks, such as market movement not aligning with predictions and increased costs due to transaction fees and volatility changes.

## Exploring Risk Reversal Strategies

Risk reversals, or [protective collars](https://www.investopedia.com/terms/c/collar.asp), hedge a position by using options. You buy one option and write another. The bought option requires a [premium](https://www.investopedia.com/terms/p/premium.asp) payment, while the [written](https://www.investopedia.com/terms/w/writing-an-option.asp) option generates income. This income can lower or even negate the cost of the trade. However, the written option also caps potential profits from the position.  

Another protective strategy that uses three option contracts to provide a range around the underlying security is the [fence strategy](https://www.investopedia.com/terms/f/fence-options.asp).

A risk reversal aims to profit from price changes in an asset while reducing upfront costs using premiums from sold options. Traders use them when they have a market view and want to offset option costs creatively.

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.

## How Risk Reversals Operate

When an investor is [short](https://www.investopedia.com/terms/s/short.asp) on an asset, they use a long risk reversal by [buying a call option](https://www.investopedia.com/articles/active-trading/070914/risk-reversals-stocks-using-calls-and-puts.asp) and writing a put option. If the asset's price rises, the call gains value and counters losses. If it falls, the investor profits until the put's strike price is reached.

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](https://www.investopedia.com/terms/s/strikeprice.asp) of the written call.

## Risk Reversals in Forex Trading

A risk reversal in [forex trading](https://www.investopedia.com/articles/forex/073115/can-forex-trading-make-you-rich.asp) refers to the difference between the implied volatility of [out of the money](https://www.investopedia.com/terms/o/outofthemoney.asp) (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.

## Understanding Ratio Risk Reversals

Ratio 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](https://www.investopedia.com/terms/a/asymmetrical-distribution.asp) 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.

> **Fast Fact**
>
> 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.

## Mastering Calendar Risk Reversals

Another 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](https://www.investopedia.com/terms/t/timedecay.asp) 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.

## Challenges and Limitations of Risk Reversals

One 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](https://www.investopedia.com/terms/i/illiquid.asp). 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.

## Practical Example: Risk Reversal in Action

Sean is long on General Electric ([GE](https://www.investopedia.com/markets/quote?tvwidgetsymbol=ge)) at $11 and wants to hedge, so he starts a short risk reversal. With GE around $11, he buys a $10 put option and sells a $12.50 call option. Let’s assume the stock currently trades near $11. Sean could buy a $10 put option and sell a $12.50 call option.

The call option is OTM, so its premium is less than the put's premium, leading to a [debit](https://www.investopedia.com/terms/d/debit.asp). This protects Sean from prices below $10, as the put offsets losses. If GE's price rises, Sean profits only up to $12.50, where the call limits further gains.

## How Do Risk Reversals Work?

Risk reversals work by establishing a position in the options market that is either skewed towards bullish or bearish sentiments. For instance, in a bullish risk reversal, an investor might buy a call option. This position would benefit from upward price movement. At the same time, the investor could sell a put option.

## How Does Implied Volatility Impact Risk Reversals?

When implied volatility is high, option prices tend to be more expensive, impacting the overall cost and potential returns of a risk reversal strategy.

## When Is the Best Time to Implement a Risk Reversal?

Traders often consider factors such as upcoming events, earnings announcements, or anticipated market trends when timing the implementation of a risk reversal. Additionally, you should assess the implied volatility levels and the cost of options as both can influence the decision of when to enter into a risk reversal position.

## How Do Risk Reversals Differ From Other Option Strategies?

Unlike a basic call or put purchase, a risk reversal combines elements of both bullish and bearish positions. This unique structure allows investors to tailor their exposure to market movements while managing costs.

## The Bottom Line

Risk reversals are options trading strategies that involve buying and selling options to hedge positions and manage risk. They allow investors to express a directional view—by buying a call and selling a put option, or vice versa—thus mitigating upfront costs. A risk reversal can protect gains on a long or short position while limiting potential profits. However, the strategy still carries risk if market movements are not as anticipated. Investors must consider implied volatility, transaction costs, and market conditions before engaging in this strategy.