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Risk reversal is a commonly used option strategy combining the simultaneous purchase of out-of-the money calls (puts) with the sale of out-of-the money puts (calls).
The options will have the same expiration date and similar deltas. In commodities trading it is used for hedging which consists of selling a call and buying a put option. This strategy protects against unfavourable, downward price movements but limits profits that can be made from favourable upward price movements.
In foreign-exchange trading, risk reversal is the difference in volatility (delta) between similar call and put options, which conveys market information used to make trading decisions.
The risk reversal has its underpinnings from the limitations of Black Scholes Merton (BSM) model. BSM model does not assume that the underlying will trade at extreme prices from the current spot market more frequently than a normal distribution would suggest. But in foreign exchange (FX) market prices move to extremes more frequently and these extreme levels is referred to as “Fat Tails”. If more price actions occur at the fat tails, the option trader will mark volatility higher for out-of-money (OTM) and in-the-money (ITM) options then at-the-money (ATM) options. If there is no bias in market expectations of the underlying price then the price of volatility is symmetrical around ATM options.
This is commonly referred to as volatility smile. In practice there are market expectations built into option prices, this pushes up the volatility for ITM calls relative to those of the puts or OTM puts relative to calls. This is referred to as “skew”.
Risk reversal is a manner in which similar OTM call and put options are quoted. Instead of quoting these option prices dealers quote their volatilities. The greater the demand for options contract, the greater is its volatility and its price.
A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the price of the underlying security than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the market and can convey information to make trading decisions. For example, suppose a three-month call option with a delta of 25 is quoted with an implied volatility of 20 and a three month put option with a similar delta is quoted with an implied volatility of 19. Since volatility is greater for a call option and it implies bullish sentiment. This information can be used for trading decisions. Note that a delta of 25 means there is a 25 per cent chance of option expiring in the money.
>shaurya.mishra@thehindu.co.in
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