Risk reversal is an options trading strategy resulting in a synthetic short or long position. It involves buying one type of out-of-the-money option (call/put) and selling the other type of out-of-the-money option (put/call) at the same time.
To create a synthetic long, requires buying out-of-the-money calls and selling out-of-the-money puts. Depending on the premium paid for buying the call and received for selling the put, this strategy may have positive returns if the stock price rises above the call strike price. If the stock price ends up between the put strike price and the call strike price then the investor loses the initial cost of the strategy or keeps any proceeds if the strategy was put on for credit. If the stock price falls below the put strike price then the investor will be assigned on the put which means the stock will be purchased on the investor’s behalf at the put strike price which may be higher than the market.
A synthetic short is accomplished by doing the reverse.
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