Risk Reversal: An Options Strategy for Low-Risk Profiles

When trading an asset such as cryptocurrencies, accounting for volatility is a must due to the potentially huge swings in prices that can occur at a moment's notice. That's where proper risk management and position hedging are crucial. They minimize your exposure as a trader, and help you make more small calculated bets without blowing up your account. 

One such example of portfolio hedging is risk reversal options, an investment strategy that can be used for both long and short positions. Keen to find out how? We’ll uncover all you need to know about risk reversal strategies and the potential benefits you can reap from employing such a strategy.

Key Takeaways:

• Risk reversal strategy protects a long or short position against unexpected movements with the use of options contracts. 
• If a trader has an existing long position, a short risk reversal strategy can be executed.
• If a trader has an existing short position, a long risk reversal strategy can be executed.

What Is a Risk Reversal Strategy?

Risk reversal refers to the active hedging strategy of using options contracts to protect a long or short position against unexpected movements. This can range from writing calls and buying puts for long positions to writing puts and buying calls for short positions. While this risk reversal options strategy is often employed for forex and equity traders, it can also be applied in the crypto space, given the availability of options contracts.

How Does a Risk Reversal Strategy Work?

A risk reversal options strategy has two parts. If a trader has an existing long position, a short risk reversal strategy can be executed in which the trader writes a call contract and buys a put contract. This effectively puts a limit on the potential upside while accounting for possible downside on the existing long underlying position.

Conversely, if a trader has an existing short position, a long risk reversal strategy can be used. This is when a trader writes a put contract and buys a call contract. In essence, this puts a cap on potential profits while taking into account any potential volatility for the short position. 

Although such an options hedging strategy is complex, due to its multi-legged nature, it can be especially useful in crypto markets if traders are expecting some form of explosive upward or downward movement for their crypto portfolio. That’s why it’s essential for those who understand the nature of crypto options to try their hand at executing this hedging strategy, instead of simply holding and hoping the sentiment changes in their favor.

Advantages of Using a Risk Reversal Options Strategy

As a hedging strategy that helps traders to manage their portfolios and limit risks, this crypto options strategy has numerous advantages, such as the ones listed below.

Controlled Market Exposure

Thanks to the combination of bought and written options, traders can control their exposure to the market, based on market sentiment, without the need to offload their existing underlying positions. From accounting for near-term catalysts to collecting additional premiums, traders can tweak their risk reversal strategy to fit their risk appetite when it comes to overall exposure. For instance, if a trader wants to hedge against a potential drop in price, they can select an option that pays out if the price drops below a certain level. 

Speculation With Minimum Risk

The other noteworthy benefit of risk reversal options strategies is that traders can use them to speculate on future market prices without risking excessive capital. This allows traders to benefit from the expected directional movement of an asset without having to put up additional capital or close their existing underlying position. 

Disadvantages of Using a Risk Reversal Options Strategy

The act of executing a risk reversal options strategy for your crypto portfolio also comes with its own set of risks and downsides, such as the following.

Complexity of Crypto Options Strategies

One disadvantage of using risk reversal options strategies is that they can be complicated to understand and execute, making it difficult for novice traders to take advantage of opportunities. 

Whether writing options at the right strike price to derive maximum value, or buying options at a far off enough strike to ensure that the position is sufficiently hedged, the losses incurred can be greater in certain scenarios if traders don’t research the potential upside and downside when executing such a complex derivatives strategy.

Costs of Running Multi-Legged Crypto Options Strategies

There can also be higher transaction costs associated with using this type of strategy, due to the multi-legged options buying and writing involved. As there’s a need for more than one leg of the options strategy open for the position to be considered hedged, certain costs are incurred. On top of this, there will also be opportunity costs incurred, since potential profits will be forgone if the price goes in the opposite direction from that for which the position was meant to be hedged.

How to Use the Risk Reversal Options Strategy

Now that you’re fully aware of the benefits and risks associated with utilizing long and short risk reversal options strategies, let’s take a look at the specifics of executing such a derivatives hedging strategy. 

For example, let's go with Bitcoin, having a reference price of $26,000. If you intend to long BTC, but want to hedge against an upcoming bearish catalyst, you’ll want to execute a short risk reversal options strategy. In this case, we’ll be looking at writing a call contract for the first leg of the short risk reversal options strategy for the long BTC position. While actual strike prices may differ, depending on your personal risk appetite, a conservative estimate would be writing a call with about a 0.3 delta. In this case, taking a look at the BTC options chain with a Jul 28, 2023 expiration date, writing the 28000c call contract would be suitable in this scenario.

For the long put leg of the short risk reversal options strategy, if you’re expecting a 5% correction in the coming weeks, BTC traders can play the runup to this by purchasing an out-of-the-money (OTM) put contract. In this case, traders can consider the 25000p with a Jul 28, 2023 expiration date. In the short run, this can result in a profit — if BTC’s price moves exactly as expected — if the 28000c contract expires out-of-the-money, while the 25000p contract expires in-the-money (ITM).

Breakdown of the Risk Reversal Strategy

Based on the example above, the sale of the call option will provide an immediate premium that can be used to offset part of the premium cost incurred when purchasing the put option. Having these two positions in place mitigates any potential losses on the downside if the underlying asset drops below the current price of BTC. However, if the stock rises above the call strike price, then there’s still potential for gains, as the amount gained from selling BTC at the call’s strike price will exceed those from purchasing the out-of-the-money put contract.

As for the risks of this crypto options strategy, one key consideration for BTC options traders is that there will always be an opportunity cost associated with taking on this kind of hedging position. If Bitcoin gains momentum and rallies, then the existing long position will be sold at the aforementioned $28,000 strike price because of the written call contract. This means that the trader will miss out on any potential gains from a further increase in the price of Bitcoin.

Is the Risk Reversal Options Strategy Worth Trying?

Based on the pros and cons listed above, it’s clear that the risk reversal options strategy can be beneficial for both beginning and experienced traders. 

For beginners, it’s a great way to get started with trading BTC and ETH options without risking too much capital. While there is a barrier to entry when it comes to executing the strategy, this can be compensated for with paper trading and doing the required research to familiarize oneself with the option strategy. 

By writing OTM contracts and purchasing ITM contracts, traders can limit their losses while preserving potential gains from an increase in the price of their preferred cryptocurrency.

Moreover, experienced traders may consider this specific crypto options strategy when trying to protect their existing positions and balance out their portfolio, minimizing the negative impacts of a volatile market. That said, beginners and those unfamiliar with options should be aware of the risks involved, and exercise caution when executing this options strategy.

The Bottom Line

All in all, hedging a crypto portfolio with derivatives has the potential to achieve capital preservation, or even appreciation, in a volatile cryptocurrency market. By writing out-of-the-money contracts and purchasing in-the-money contracts with long and short risk reversal option strategies, respectively, traders can reduce their risk while retaining the chance to benefit from potential price increases. 

At worst, the underlying position is sold for a profit, thanks to the OTM contract being exercised. And at best, the opposing position pays off — and the hedge provides a crypto trader with a tidy profit, even as they hold onto their underlying position.

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