The risk reversal strategy is a technique used by advanced binary options traders to reduce their risk when executing trades. Although it is sometimes considered to be a hedging strategy, it is actually more of an arbitrage as it necessitates a purchase of put and call options simultaneously.
While this strategy is able to generate a profit with absolutely no risk to the trader, it is a fairly complication strategy to put into place and needs some practice. However, although it can take a while to master this strategy, the profits from developing this skill are worth its while.
How Does the Risk Reversal Strategy Work?
The first step of using the risk reversal strategy is to identify an asset which you expect to increase in price. While most traders will execute a call option on this asset once it has been identified, making a capital investment, there is another way to place an identical position on this same asset but without any investment at all and you will still be able to make a profit from the call options should the bullish run materialise.
This bullish position can be activated by purchasing a out of the money call option and also, at the same time, sell an out of the money put option. The key here is to ensure that both trades are with the same asset, the same wagered amount, and the same expiry time. This means that you will have executed the trade with the asset that you have chosen and yet you have not spent anything as the cost of executing the call option will be balanced equally by the money you receive when you sell the put option.
This is because when the price of the asset starts to rise, the call option will climb higher and at the same time, the put option declines to zero by the end of its expiry period. This means that you make a profit on the call option but will get no refund from your put option. You have therefore made a trade that is in the money without risking any of your own money.
For this reason, the risk reversal strategy is very popular withy experienced traders as they can earn impressive profits while taking minimal risk. This strategy also has the advantage of have an unlimited profit potential.
How to Trade Using the Risk Reversal Strategy
The risk reversal strategy can be used even if the trader has other active positions with either the same or other assets. This strategy also helps with hedging trades. To do this, a trader can purchase a call option and sell a put option subsequently if the sentiment of the investor is bullish on the asset. Should sentiments be bearish, the trader can buy a put option while selling a call option in order to activate the hedge.
This is not a service that is offered by every binary options broker however. In order to benefit from using this advanced strategy, you will require an updated brokerage account which enables the processing of pending orders. If you wish to try your hand at the risk reversal strategy, you should carry out checks with your chosen broker to see if they can offer a full sell functionality as this is needed to sell the put option back to the broker. Some brokers will ask the trader to upgrade their account if they wish to use this risk reversal strategy, so you should talk to your binary options broker in order to determine whether your account type will need to be upgraded in order to take advantage of this strategy, or whether you will be able to use your standard account for this purpose.
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- Brunnermeier, M.K., Nagel, S. and Pedersen, L.H., 2008. Carry trades and currency crashes (No. w14473). National Bureau of Economic Research.
- Jegadeesh, Narasimhan, and Sheridan Titman. “Profitability of momentum strategies: An evaluation of alternative explanations.” The Journal of Finance 56, no. 2 (2001): 699-720.