Just as calendar spreads isolate the benefit of differences in time decay, risk reversals isolate the phenomena of skew to the option trader’s advantage. With a risk reversal, option traders get to sell expensive options while buying cheap options, usually get to pocket some premium, and get long exposure to a stock they think is going to appreciate—all while generating a potentially significant margin of error in which the worst thing that happens is the risk reversal expires worthless and they keep any premium received. While it’s possible to establish a risk reversal at a debit, and we’ll discuss that later, it’s generally best for a risk reversal to generate a net credit, even if it’s small. Likewise, any net debit should be relatively small.
A risk reversal is constructed by selling a put option and buying a call option of the same expiration, but with a higher strike price. The premium received for selling the put option is generally greater than the premium paid in buying the call option. This difference is due to skew and results in the standard risk reversal generating a net credit to the option trader, even if the call is the same distance from at-the-money as the put. If the risk reversal were done for zero net premium, we would expect the call option bought to be closer to at-the-money than the put option sold.
The XYZ 95/105 risk reversal shown in Table 13.1 would consist of being long the XYZ 105 strike call option at a cost of $2.50 and ...