The original risk reversal is simply the collar position without the stock shares. It is the long put and short call.
The reason for it not simply being called “the collar” is because there were no electronic online brokers that could execute a collar as a package (long stock, long put, short call) when the concept of hedging stock with a collar arrived on the floors. An investor typically bought shares (or already owned shares) and then hedged the shares with a long put and short call to finish the collar.
So the investor’s broker would be responsible for putting the option portion of the order into the trading pit. They would often package the call and put together, instead of executing the call and the put separately. This eventually came to be known as a risk reversal, since it was reversing the risk of being long stock.
Long Call Spread
When buying a long call spread there is a cost associated with it, and usually the call spread is purchased OTM so as to obtain a good risk-reward-ratio.
What this means is that, if the stock does not appreciate substantially in price, not only will you not make money, but you will lose money on your initial investment. You must be correct in your assessment that the price of the underlying is moving higher, and you also have to have it rise above the furthest OTM strike of the call vertical spread.
Short Put Spread
Selling a put spread is essentially the same thing as purchasing a call spread.
The good news about selling a put spread (or call spread sale) is that the requirements for a profit are not as demanding (typically). Selling an out-of-the-money (OTM) put spread (or call spread) allows the trader much more wiggle room for the stock to move, albeit at a sacrifice to the risk vs. reward ratio.
When selling a put spread you can make the full value of the sale price should the stock run higher, stay flat, or even fall a little. Many people find this to be a more favorable position despite the risk vs. reward imbalance.
Combining the Positions
The risk reversal (which is a position when not used as a hedge) is designed to take advantage of the positive risk vs. reward ratio of the long vertical spread, and the excellent chance of success with the short vertical spread.
The best way to think of a risk reversal is as a strategic position that uses the capital from the sale of a vertical spread to subsidize the purchase of the long vertical spread.
Below is an example of the combined positions:
Typical Risk Reversal
An option trader will typically do a risk reversal for about even money (regardless of whether it is a purchase or a sale). This means that the sale of one vertical spread and the purchase of another vertical spread will be roughly the same distance OTM. In addition, the contract size will usually be the same (example: Long 10 call spreads and short 10 put spreads).
Want more of Risk Reversals?
Randomwalk’s Option Trading Guide to Understanding Risk Reversal – Part 1 Book discusses the step by step criteria complete with examples to help option traders get a better understanding of the strategy. It also shows a different approach to Risk Reversal, aside from the typical one.
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