Risk reversal

Risk reversal can refer to a measure of the vol-skew or to an investment strategy.

Risk Reversal investment strategy

A risk-reversal consists of being short (selling) an out of the money put and being long (i.e. buying) an out of the money call, both with the same maturity.

A risk reversal is a position in which you simulate 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.

$R_{25} = \sigma _{call,25} - \sigma _{put,25}$

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 price and hence the greater its implied volatility. A positive risk reversal means the implied volatility of calls is greater than the implied 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

1. ^ http://www.quantprinciple.com/invest/index.php/docs/quant_strategies/riskreversal/ Theory of Risk Reversal