Let’s focus on the Risk Reversals (RR) in this post, a term that is generally more used in an IB or HF but we believe a term important to know. Generally speaking, a risk reversal is an option strategy that combines the purchase of OTM calls (resp. puts) with the sale of OTM puts (res. calls), similar deltas and same tenors. Let’s have a look at the two different RR strategies you can create:
1. Bullish Risk Reversal (Short OTM put and Long OTM call)
For those who expect an appreciation of the underlying asset. For instance, in this case, an American company will need to raise 1 Mio EUR in 3 months in order to pay the product delivery. EURUSD is now trading at 1.3550, and the company wants to secure a maximum rate of 1.3900.
Strategy: Bullish Risk Reversal will allow the company to buy EURUSD within the range 1.3200 – 1.3900.
– If the price is below 1.3200, the American company will start to lose money as they will have to buy the pair at 1.3200.
– If Spot rate trades within the 1.3200 and 1.3900 range, the company will buy EURUSD at market.
– If the price is above 1.3900, they will buy the pair at 1.3900 and generate a positive PnL.
2. Bearish Risk Reversal (Short OTM call and Long OTM put)
For those who expect a depreciation of the underlying asset. For instance, in this case, a French company will need to sell 1 Mio EURUSD in 3 months in order to pay the product delivery. The pair is now trading at 1.3550, and the company wants to secure a rate level of 1.3200.
Strategy: Bearish Risk Reversal that will allow the company to sell EURUSD within the range 1.3200 – 1.3900.
– If the price is below 1.3200, the French company will start to generate some money as they will sell the pair at 1.3200 (above market).
– If Spot rate trades within the 1.3200 and 1.3900 range, the company will sell EURUSD at market.
– If the price is above 1.3900, they will start to lose money as they will have to sell at 1.3900(below market).
This option strategy is generally used for hedging, however it can also be used for leveraged speculation.
Bloomberg application: If you type Risk Reversal on Bloomberg (Ticker: WCRS RR), you get the page below which shows this different RR figures for the G10 currencies (vs the USD) for a maturity of 1 Month.
For example, we have a RR = -0.67 for EUR. In short, it means that the implied volatility (IV) of a 25 Delta Call is less than the IV of a 25 Delta Put.
Let’s start with the definition of a 25 Delta option. A 25-Delta Call refers to a call option OTM (Strike above the current spot rate); if the underlying asset, in that case the pair EURUSD, increases by 1, the call option value will rise by 0.25 (by unit, not percentage). I am sure you’ve already heard of the ‘Greeks’ (Hull study) and the famous Delta (Delta hedge strategy). Delta, in fact, is the first the derivative of the Value of the option with respect to the underlying asset price.
Implied volatility, or IV, is the estimated future volatility. It is usually computed using a Black-Scholes model (or equivalent) for options pricing. You know that a vanilla option depends on 5 parameters: Underlying, Strike, Vols, Interest Rate and Time. As you have the price of the option (by the market), you can ‘reverse’ the formula and get the implied vol of the option (dichotomy method for instance).
The IV (25-Delta call 1M) is at 6.50 and the IV (25-Delta put 1M) is at 7.17. Therefore, from the following relation:
RR (25-Delta 1M) = IV (25-Delta call 1M) – IV (25-Delta pit 1M)
We effectually have a RR 25D 1M of -0.67.
A negative RR 25 on EURUSD 1 month means that prices of puts are more expensive than calls, telling investors the market is more bearish on EURUSD for the month to come.
Usually, the ones that investors look at are the RR 25 Delta 1 Month. However, the RR 1M 10-Delta are also popular with the Butterfly (we will see the definition in another post).