Risk reversal
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Risk Reversal
1. In commodities trading, it is a hedge strategy that consists of selling a call and buying a put option. This strategy protects against unfavorable, downward price movements but limits the profits that can be made from favorable upward price movements.
2. 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.
Investopedia Says:
1. For example, say Producer ABC purchased an $11 June put option and sold a $13.50 June call option at even money (put and call premiums are equal). Under this scenario, the producer is protected against any price moves in June below $11 but the benefit of upward price movements reaches the maximum limit at $13.50.
2. Risk reversal refers to the manner in which similar out-of-the-money call and put options, usually FX options, are quoted by dealers. Instead of quoting these options' prices, dealers quote their volatility. The greater the demand for an options contract, the greater 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 currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the FX market and can convey information to make trading decisions.
Related Links:
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Learn about this hedge ratio, which tells us how many contracts are needed to hedge a position in the underlying. Going Beyond Simple Delta: Understanding Position Delta
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Wikipedia on Answers.com:
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Risk reversal
Risk reversal can refer to a measure of the vol-skew or to an investment strategy.
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Risk Reversal investment strategy
A risk-reversal consists of being short (selling) an out of the money call and being long (i.e. buying) an out of the money put, both with the same maturity.
A risk reversal is a position in which you simulate to the behavior of a long, therefore it is sometimes called a synthetic long. This is an investment strategy that amounts to both buying and selling out-of-money options simultaneously. In this strategy, the investor will first make a market hunch, if that hunch is bullish he will want to go long. However, instead of going long on the stock, he will buy an out of the money call option, and simultaneously sell an out of the money put option. Presumably he will use the money from the sale of the put option to purchase the call option. Then as the stock goes up in price, the call option will be worth more, and the put option will be worth less.[1]
If an investor holds the underlying (stock or FX) and sells a risk reversal, then he has a collar position. i.e.
- Underlying - Risk_Reversal = collar
Risk reversal (measure of vol-skew)
Risk Reversal can refer to the manner in which similar out-of-the-money call and put options, usually foreign exchange options, are quoted by Finance dealers. Instead of quoting these options' prices, dealers quote their volatility.
In other words, for a given maturity, the 25 risk reversal is the vol of the 25 delta call less the vol of the 25 delta put. The 25 delta put is the put whose strike has been chosen such that the delta is -25%.
The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies a skewed distribution of expected spot returns composed of a relatively large number of small down moves and a relatively small number of large upmoves.
References
- ^ http://www.quantprinciple.com/invest/index.php/docs/quant_strategies/riskreversal/ Theory of Risk Reversal
Other external links
- Reuters description: http://glossary.reuters.com/index.php?title=Risk_Reversal
- Investopedia description: http://www.investopedia.com/terms/r/riskreversal.asp
- Quant Principle: Risk Reversal Case Study
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