Definition of Bearish Risk Reversal

What is a "bearish risk reversal" in the world of options? What is meant by a bearish risk reversal?

A bearish risk reversal consists of two parts:

1. First, you sell calls.

2. Second, you buy puts.

A "bearish risk reversal" play would be executed on a stock or asset that you feel is going to drop in price over a certain time frame.





Let's say that you are bearish on Tesla. The stock is currently trading for $200. You feel that over the next month, the stock has a very good chance of dropping.

Now, you could just buy puts, though a bearish risk reversal allows you to finance the purchase of your puts with the sale of calls.

So, in this case, let's say that the $200 calls that expire in a month are currently trading for $9.50, while the puts at the same strike are trading for $11.25.

A bearish risk reversal could look like this:

1. Sell 1 $200 call at $9.50.
2. Buy 1 $200 put at $11.25.

In this situation, you are almost completely financing the purchase of your put with the sale of your call.

The downside to bearish risk reversal plays is that you have unlimited downside with the call. If Tesla is bought for $250/share, you would incur a large loss.

If you just purchased a put, for instance, your loss would be limited to the amount of the put premium.

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Let's say that Tesla closes at $180 when the two options expire.

You would keep 100% of the premium from selling the call, which would represent $950.

Also, your put option would be worth $20, for a total profit of $8.75, or $875.

This means that you would walk away from the trade with a total profit of nearly $2,000.

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Risk reversal plays are quite popular with hedge funds.

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