Risk Reversal, also known as a Protective Collar, is a hedging strategy to protect either a long or short position by using put and call options. It protects against unfavorable price movements at the expense of potential profit.
If an investor is short an underlying asset, the investor hedges the position with a long risk reversal by purchasing a call option and writing a put option. Likewise, if an investor is long, they short a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying asset.
This hedge requires a combination of option calls and puts and therefore is only suitable for savvy investors.
The risks for this strategy are low based on the put and call positions obtained.
Low to Moderate
Based on the execution of two options, the premiums help offset the costs.
You are long in soybeans at $900 and want to protect the position by constructing a short risk reversal. To accomplish this, you need to do the following:
Consider that you can buy a put option for $890 and sell a $910 call option. Since the call option is out-of-the-money (delta lower than 50), the premium received will be less than what you pay—causing the trade to result in a debit.
In this scenario, you have protection against price moves below $890. However, your profit is limited to $910 since the written call will offset additional gains.
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.