Risk reversal is an options trading strategy used to hedge risk. The strategy protects against adverse movements but at the same time limits potential profit. A trader buys one option and other write depending on a position in underlying. Income from the written option can outweigh the premium paid for buying one.
Long risk reversal is used to hedge the short position in an underlying instrument. The investor buys the call option and sells the put option. If price increases, the call gain value, redeeming the loss on the short position. If the price falls, short position gains but the profit is limited to the level of the strike price.
Short risk reversal is used to hedge long positions in an underlying asset. In this case, a trader sells a call and buys a put option. If the price drops, he gains in the put option which should redeem the loss in the underlying. On the contrary, if price rises, the increase in value is limited to the strike price of the written call.
In foreign exchange, a risk reversal, or combo, represents the difference in implied volatility of out of the money calls and OTM puts. OTM call option means the strike price is higher than the market price of the underlying asset, and OTM put has a lower strike price than the market price of the underlying.
Demand drives the volatility. If the volatility of calls goes beyond the volatility of puts than we have positive risk reversal. In this case, more investors think the value of the currency will rise, thus calls have greater value than puts. Similarly, negative risk reversal means the market is overall bearish betting more on a falling price valuing more puts than calls.
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