What is a risk reversal?

By , CEO of Volcube.

The definition of a risk reversal

A risk reversal (also known as a combo in some markets) is a put of one strike traded against a call of a higher strike. For example, the 95/105 risk reversal means the 95 puts are bought (or sold) and the 105 calls are sold (or bought respectively). It is most common for the put and the call options to both be out-of-the-money when the risk reversal is initiated.

Why trade a risk reversal?

There are several reasons for wanting to trade a risk reversal. The risk reversal can be a form of delta hedging. For example, an investor may want to protect his asset from downside price risks. So, he considers buying a put. Now, if he is prepared to limit his upside potential on the underlying asset, he can also consider selling a call in order to finance buying the put. In this way, it can be possible to create a position, at no initial cost, that is is protected from large downside price movements.

Another common use of risk reversals is as a means to trading option skew. Suppose the trader think that the implied volatility of puts relative to calls is too high. He might consider selling puts to buy calls (i.e. trading a risk reversal). Now the trader is likely to delta hedge a combo when it is executed as a skew play. This is because he is interested in the implied volatility levels of the options rather than their actual dollar values. So delta hedging the risk reversal is a way to concentrate the trader’s exposure in terms of the implied volatility. Remember that delta hedging options effectively turns the strategy into a volatility play, rather than a directional play.

Pricing a risk reversal

When a trade prices a risk reversal/combo as a skew trade he will be more interested in the implied volatility levels than in the actual dollar value of the options. Suppose his model uses implied volatility levels of 25% for the put options and 20% for the call option. In making a price in this combo, he will need to consider how accurate his model is in terms of implied volatility. In other words, he needs to think whether 25% for the puts is too high/too low/about right and likewise for the call.

Risk managing a risk reversal

Risk reversals can be amongst the most challenging of all option strategies to price and manage. Depending on the strikes of the put and the call in question, a risk reversal may have high or indeed low levels of vega, gamma, theta, vomma and vanna. To simplify this, the combo is often selected so that the put and call have similar levels of these Greeks and therefore many of them broadly cancel one another out. This is particularly common with respect to risk reversals when used as skew trades. If the trader is primarily interested in the difference between the implied vol levels of the put and the call, he will generally want to minimise all other exposure. Choosing a put and a call with similar values of the Greeks is one way to do this (since obviously as the trader is selling one options and buying the other, much of the Greek risk will disappear).

A couple of caveats. Firstly, vanna is not minimised by trading a combo; it is pretty much maximised! Unlike say vega, which is positive for all options, vanna is positive for calls but negative for puts, so buying one option and selling the other has a doubling effect. Vanna is often an important risk to be aware of for risk reversal traders.

A second point to note is that typically the spot product does not sit still! With the spot trading 100, the 95/105 combo as a net position may have relatively low Greek risk. But if the spot drops to 95, the picture may be altogether different. Essentially, due to put-call parity, the risk reversal mutates with the spot below 95 to being equivalent, broadly, to the 95/105 call spread. The risk of such a position is likely to be markedly different when this happens, because the 95 strike Greeks will generally be higher than the 105 strike Greeks and so the position is less ‘spread-off’. Some traders will therefore look to ‘roll’ their position when the spot moves, so as to maintain something closer to their initially desired exposure.

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