Risk reversal

A risk reversal combines a long out-of-the-money call and a short out-of-the-money put on the same expiry, or the reverse. It is both a directional position and the standard way to quote skew. In FX, the 25-delta risk reversal is a quoted market in its own right.

How it works

As a position, a long risk reversal gives upside exposure above the call strike and full downside exposure below the put strike, with nothing in between. It is long delta and its vega depends on the relative vols of the two strikes. As a quote, the risk reversal is the implied volatility of the 25-delta call minus that of the 25-delta put. On equity indices it is usually negative because puts trade richer. In FX its sign shows which side of the currency pair the market pays up to protect.

Example

Hypothetical one-month index options with spot at 100: the 25-delta put trades at 22% implied volatility and the 25-delta call at 16%, so the risk reversal is quoted at −6. A trader buys the 105 call at 0.35 and sells the 95 put at 0.75, a net credit of 0.40. At expiry at 112, the P&L is 7 + 0.40 = 7.40. At 88, it is −7 + 0.40 = −6.60. Between 95 and 105, the credit of 0.40 is kept.

On the desk

The position carries a skew exposure that is easy to overlook. If the put side reprices higher in a sell-off, the mark-to-market moves against the holder of a long risk reversal on two fronts at once: delta and skew.