Bearish Risk Reversal Short one OTM call. Long one OTM put. <Risk chart of bearish risk reversal retrieved from thinkorswim> Warning: This strategy can be VERY DANGEROUS because its potential risk is unlimited if the market rips upward. You would not want to attempt this unless you would be willing to short the equivalent of 100 shares per options contract. Intermediate: Practical Application A bearish risk reversal can be an effective tool if your trading thesis is bearish, such as expecting a bearish reversal from underneath major resistance like a Call Wall or VT (Volatility Trigger™), or if the price has fallen and become trapped under the Put Wall. A bearish risk reversal can be an effective tool if your trading thesis is bearish, such as expecting a bearish reversal from underneath major resistance like a Call Wall or VT (Volatility Trigger™), or if the price has fallen and become trapped under the Put Wall. A bearish risk reversal is a two-legged vertical spread that is usually short an OTM call and long an OTM put. It is a highly dynamic strategy where subtle changes in strike placement can make a big difference. If in doubt, then placing each strike at 25 delta is a decent approach. One reason why a trader might use a bearish risk reversal instead of shorting 100 shares is that there is a bit more margin for error if slightly wrong about direction. However, in turn, a risk reversal has less benefit if only slightly correct about direction, especially if much time has needed to go by to get to that point. Advanced: Trade Management Idea One approach to managing a bearish risk reversal would be to close the short call for a profit, such as at 50% of its max profit. Hitting a 50% target like this could happen if the underlying moves down far enough for that to happen or implied volatility has decreased by that much. The result of legging out of the short call like this would be to keep the risk capped, lock in some gains, and maintain uncapped profit exposure if there is a continuation down in the underlying security. However, at times (when not expecting a continuation) it would be better to close both legs all at once for clean profit capture on the strategy. Deciding on tactical maneuvers—such as legging out—would always need to be judged on a case-by-case basis. Expert: Synthetics If instead this bearish risk reversal was compressed into being long a put and short a call at the same strike, then this would become a synthetic short, as it would behave almost identically to being short the underlying security.If spread out at different strikes, and if this strategy is combined with 100 shares long in the underlying, then it becomes an options collar, which is one of the most popular ways to hedge long spot underlying positions. As a general principle of risk management, we always lean toward playing it safe by keeping risk defined (meaning a bias toward using wingtips on short options). This usually leads to a slight drag on the expected payout, but deep down it helps to cover tail risk and to have the trader’s career being able to survive very distressing market moves in excess of three standard deviations (more than a 99.7% chance of not happening). Holding long tails helps to give us protections of ergodicity that keep us surviving the shocks and still very capable of being consistently net profitable traders. bearish: A trade is bearish if it would profit from a decrease in the underlying (e.g. stock or future) price. Likewise, a trade thesis is bearish if it is expecting the underlying to decrease. Call Wall: The Call Wall is the strike with the largest net call gamma. This shows us what the top of the probable trading range is (the upper bound). delta: A first-order Greek that measures the sensitivity of an option's price to directional movement in the underlying security. Factoring out nonlinear dynamics, the instantaneous value of one delta is worth one share of a stock. This means that if the option on a stock is 40 delta, such as a 40 delta long call or a 40 delta short put, then instantaneously it has the same profit/loss dynamics of being long 40 shares. IV (implied volatility): The expected percentage range over a year with 68.3% confidence. This is based on options pricing at one standard deviation. Long options benefit from increases in implied volatility and short options benefit from decreases in implied volatility. In general, when implied volatility increases it means that the expected percentage range is getting larger. When implied volatility is applied to lengths of time other than one year, then this is called the expected move. leg out: Legging out of a strategy is when one part of an options spread is closed before the other part(s). For example, if one has a debit put vertical (long put and a short put at a lower strike) which loses money on a large move up in the market, then the short put can be closed for a profit. This would partially subsidize the long put and give it a chance to run without a spread if the market crashes back down. As an important point on risk management, it is always safer to leg out by closing a short option—rather than a long option—because this way the risk still remains defined (limited). long put: To be long (buy and hold) an option contract which has limited risk and unlimited potential gains from moves down in the underlying price. The max loss is the cost of the put. Going long on a put is a simple way to gain [profitable] downside exposure to movement in an underlying security, however the underlying security (such as a stock) must outperform the premium placed on that put by the options market. In other words, a long put must beat the options market in order to profit. If closed early (well before expiration) then a long put must outpace the expected move (priced in by the options market) for a specific period of time. All long puts have long gamma and long vega but short theta. It is uncommon to exercise puts rather than simply close them for a profit, however a long put is frequently understood as a right to exercise (trade in the long put to become short 100 shares) if below the specified strike price. Synthetically, a long put becomes logically equivalent to a long call if also long 100 shares. options collar: An options strategy which is long 100 shares (or an equivalent basket) and then short an out-of-the-money call and long an out-of-the-money put. OTM: An option is out-of-the-money if it would have zero value expiring with the underlying at its current price. When an option is out-of-the-money, its entire price is made of extrinsic value, which is a premium that option buyers are willing to pay for an opportunity to make a profit. Put Wall: The Put Wall is our major support level, which measures the most amount of negative gamma in the market. This shows us what the bottom of the probable trading range is (the lower bound). security: Any investment product that can be traded on an exchange, such as but not limited to stocks, futures, ETFs, options, bonds, mutual funds, and treasuries. short call: To be short (sell to open and hold) a call. Unless otherwise hedged, the owner of the short call has unlimited risk and only limited potential gains, which makes this an extremely dangerous strategy in isolation. If left to expire, a short call will achieve max profit if the price ends up underneath the strike price. Shorting a call is a way to express a thesis that one is “not bullish” such as what might be justifiably the case if testing a Call Wall from underneath; being “not bullish” is different than being bearish. For a short call to be profitable, the underlying security must underperform the premium placed on that call by the options market. In other words, a short call profits when the underlying security fails to beat the options market. To be closed early for a profit, there needs to be a decrease in implied volatility or the underlying must have increased less than the options market has priced in for that specific period of time. All short calls have short gamma and short vega but long theta. Short options also come with obligations instead of rights, which means that, at any time, shares can be assigned (100 short shares for each contract); assignment usually only happens when in-the-money and near expiration). Synthetically, a short call becomes logically equivalent to a short put if the trader is also long 100 shares. spot: The immediate delivery price of an underlying security. Shares are always considered the spot price, while options are a derivative of that. We also referred to index prices as spot—in contrast to futures or options on them. standard deviation: In statistics, a standard deviation represents the average expected move (deviation from the mean) with 68.3% confidence. Option theoretical pricing models use standard deviation as a part of their volatility measurement. strike: The price that an option is based on. A long call will expire worthless if the price of the underlying security finishes underneath the strike price, and a long put will expire worthless if the underlying finishes above the strike price. synthetics: In options, synthetics are different structures that have the same logical dynamics, including the same max loss, max profit, chance of winning, and option Greeks. Synthetics are possible because options have the property of put-call parity. For spreads, long puts can be swapped for long calls and short puts can be swapped for short calls (and vice versa) in a way that creates synthetic matches without the need of adjusting deltas with shares. On single-leg options, however, puts and calls can be swapped in the same way, but require directionally-offsetting positions in the underlying security (such as a certain amount of shares). underlying: A reference to the immediate price of the underlying security. This is also sometimes called spot (the spot price of the underlying). The spot price is in contrast to derivatives which have option prices or [forward] futures prices. vertical spread: Any option strategy which has all contracts expiring on the same date. In contrast to a horizontal spread (calendar) or diagonal spread (combination of vertical and horizontal strikes), vertical spreads are usually the most directional and also the easiest to manage. With vertical strategies, the main edge at play is usually skew (differences in implied volatility for different strikes on the same date). Implied volatility is the expected percentage range over the next year—based on option prices—with 68.3% confidence. VT (Volatility Trigger™): The VT is our proprietary indicator which detects the level below which we expect bearish feedback loops (chain reactions) to start kicking in. Above this level we expect bullish flows that lead to relatively lower market volatility. Underneath the VT, realized volatility (the expected percentage range over a period of time based on historical data with 68.3% confidence) is modeled to expand significantly. In the Equity Hub™, a similar calculation is used for what is called the Hedge Wall. Related articles Bullish Risk Reversal What is a Barrier Spread? Call Frontspread How do I interpret the Skew chart in Equity Hub™? What is a Call Backspread?