• Short one OTM put.
• Long one OTM call.

<Bullish risk reversal risk graph retrieved from OptionStrat>

A bullish risk reversal is short a put and long a call at a higher strike on the same date. This strategy can be VERY DANGEROUS because it carries severe risk if the market crashes down. You would not want to attempt this unless you would also be willing to be long 100 shares per options contract. 

All Levels: Practical Application

Opening a bullish risk reversal can be an effective strategy if testing major support such as a Put Wall (or other well-established support). One reason why a trader might use a bullish risk reversal instead of going long 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.

Intermediate: Details

A bullish risk reversal is a two-legged strategy, usually consisting of an OTM short put and an OTM long call. If instead both legs were at-the-money, then this would be a “synthetic long” strategy since it would become more of a logical match with a long position in the underlying security.

By having both strikes OTM, the effect is that there can be some adverse movement in the underlying without suffering losses, or it can incur less dramatic losses (for the same underlying moves) if closing the position early. Pictured here is a 30-day bullish risk reversal with each strike at about 25 delta. 

Advanced: Time Dynamics

If waiting until expiration, then there would be no losses if the underlying fell to where the short put is or higher. The cost of this benefit, however, is that the underlying must move up at least past where the strike on the long call is for there to be a profit at expiration. 

However, if closing before expiration, then the profit curve becomes rounded rather than flat and horizontal, which means that some losses could occur from closing early with minor drops in the underlying, and some gains could be made from closing early with minor increases in the underlying.

Expert: Synthetics

One tactical way to manage this strategy would be to close the short put for a profit, such as at 50% of its max profit if the underlying security moves up high enough. This converts the remaining position into being a single-leg long put. The result of legging out of the short put like this would be to keep the risk capped, lock in some gains, and maintain uncapped profit exposure if there is a continuation up in the underlying.

Regarding a common transposition, if both of the strikes on a bullish risk reversal are the same, then it becomes a synthetic long, which logically has the same dynamics as being long 100 shares.

bullish: A trade is bullish if it would profit from an increase in the underlying (e.g. stock or future) price. Likewise, a trade thesis is bullish if it is expecting the underlying to increase.

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. 

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 call: To be long (buy and hold) an option contract which has limited risk and unlimited potential gains from moves up in the underlying price. The max loss is the cost of the call. Going long on a call is a simple way to gain upside exposure to movement in an underlying security, however the underlying security (such as a stock) must outperform the premium placed on that call by the options market. In other words, a long call must beat the options market in order to profit. If closed early (well before expiration) then a long call must outpace the expected move (priced in by the options market) for a specific period of time. All long calls have long gamma and long vega but short theta. It is uncommon to exercise calls rather than simply close them for a profit, however a long call is frequently understood as a right to exercise (trade in the long call to be long 100 shares) if above the specified strike price. Synthetically, a long call becomes logically equivalent to a long put if also short 100 shares.

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). 

short put: To be short (sell to open and hold) a put. Unless otherwise hedged, the owner of the short put has severe risk and only limited potential gains, which makes this an extremely dangerous strategy in isolation. If left to expire, a short put will achieve max profit if the price ends up above the strike price. Shorting a put is a way to express a thesis that one is “not bearish” such as what might be justifiably the case if testing a Put Wall from above; being “not bearish” is different than being bullish. For a short put to be profitable, the underlying security must underperform the premium placed on that put by the options market. In other words, a short put 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 fallen less than the options market has priced in for that specific period of time. All short puts 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 put becomes logically equivalent to a short call if the trader is also short 100 shares.

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.