Risk reversal is a strategy often used by investors looking to gain directional exposure with reduced premium outlay.

Unlike strategies like covered calls, protective puts or collars, a risk reversal does not require holding the underlying assets.

Instead, it consists of a combination of a long outta the money put and a short outta the money call.

This is typically used to express a bearish view while accepting some upside risk.

On the other hand, a bullish risk reversal lips the structure.

It involves a short out of the money put, combined with a long out of the money call, which expresses a bullish view while accepting some downside risk.

Let's look at the bearish risk reversal in more detail.

Suppose an investor is bearish on a stock and expects the price to decline significantly, but also acknowledges some upside risk.

Instead of buying a put outright, which can be expensive, the investor buys an out of the money put with a strike price of $46, and simultaneously sells an outta the money call with a strike price of $54.

Let's imagine the current stock price is 50.

The premium received from selling the call partially or fully offsets the cost of the puts, reducing the net premium paid for downside protection.

Now, let's consider the payoff profiles.

A long put alone generates profits if the stock declines sharply, but it comes at a cost.

A short call alone generates income from the premium received, but exposes the investor to potential losses if the stock price rises above the call strike.

By combining these positions, the investor benefits from downside exposure at a lower cost than an outright put purchase.

If the stock falls sharply, the long put gains value allowing the investor to profit from the downside move.

However, if the stock rallies significantly, the investor faces losses beyond the call strike as they are obligated to sell at $54, limiting their ability to benefit from further upside.

The key advantage of a risk reversal is that it provides a directional position with limited upfront cost compared to simply buying a put.

This strategy is more cost effective since the call premium reduces the overall expense, The investor benefits from lower upfront costs, but at the expense of introducing upside risk if the stock rallies beyond $54 losses begin to accumulate.

This brings us to some important considerations.

First, while the long puts provides downside exposure, it only becomes valuable once the stock price falls below $46.

Second, if the stock rises beyond the short call strike at $54, losses begin to accumulate, making it crucial to manage the risk of a strong rally.