Risk Reversal

AAA

DEFINITION of 'Risk Reversal'

1. In commodities trading, it is a hedge strategy that consists of selling a call and buying a put option. This strategy protects against unfavorable, downward price movements but limits the profits that can be made from favorable upward price movements.

2. In foreign-exchange trading, risk reversal is the difference in volatility (delta) between similar call and put options, which conveys market information used to make trading decisions.

INVESTOPEDIA EXPLAINS 'Risk Reversal'

1. For example, say Producer ABC purchased an $11 June put option and sold a $13.50 June call option at even money (put and call premiums are equal). Under this scenario, the producer is protected against any price moves in June below $11 but the benefit of upward price movements reaches the maximum limit at $13.50.

2. Risk reversal refers to the manner in which similar out-of-the-money call and put options, usually FX options, are quoted by dealers. Instead of quoting these options' prices, dealers quote their volatility. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the FX market and can convey information to make trading decisions.

RELATED TERMS
  1. Exchange Rate

    The price of a nation’s currency in terms of another currency. ...
  2. Put Option

    An option contract giving the owner the right, but not the obligation, ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) ...
  4. Premium

    1. The total cost of an option. 2. The difference between the ...
  5. Spot Price

    The current price at which a particular security can be bought ...
  6. Foreign-Exchange Risk

    1. The risk of an investment's value changing due to changes ...
RELATED FAQS
  1. What options strategies are best suited for investing in the aerospace sector?

    The best options strategies for investing in the aerospace sector exploit the sector's volatility and propensity for big ... Read Full Answer >>
  2. What options strategies are best suited for investing in the Internet sector?

    The long straddle and long strangle options strategies enable investors to capitalize on the Internet sector's volatility. ... Read Full Answer >>
  3. How many attempts at the Series 7 exam are permitted?

    The National Association of Securities Dealers (NASD) has not placed any limits on the number of times you can attempt to ... Read Full Answer >>
  4. Where can I buy covered call ETFs (exchange-traded funds)?

    Covered calls can be traded through any major retail broker. Investors need to have their brokerage accounts approved for ... Read Full Answer >>
  5. How do I set a strike price in a put?

    The strike price of a put option is the price at which the option can be exercised. A put option gives the buyer, or holder, ... Read Full Answer >>
  6. How can I profit from a decline in the drugs sector?

    Profit from a decline in the drugs sector by short selling or by purchasing futures contracts or put options. Investors use ... Read Full Answer >>
Related Articles
  1. Options & Futures

    Capturing Profits With Position-Delta Neutral Trading

    This trading strategy will show you how to gain from a decline in implied volatility on any movement of the underlying.
  2. Options & Futures

    Options Trading Strategies: Understanding Position Delta

    Learn more about the position delta hedge ratio and how it can tell you the number of contracts needed to hedge a position in the underlying asset.
  3. Options & Futures

    Options On Futures: A World Of Potential Profit

    There's one simple hurdle in the transition from stock to futures options: learning about product specifications.
  4. Options & Futures

    An Option Strategy for Trading Market Bottoms

    The reverse calendar spreads offers a low-risk trading setup that has profit potential in both directions.
  5. Options & Futures

    Gauging Major Turns With Psychology

    Knowing what the market is thinking is the best way to determine what it will do next.
  6. Fundamental Analysis

    Explaining the Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio.
  7. Options & Futures

    Why Is Best Buy Stock So Volatile?

    We look at why BBY has been so volatile in the past and whether this trend is likely to continue or abate in the future.
  8. Investing Basics

    What is a Stock Option?

    An employee stock option is a right given to an employee to buy a certain number of company stock shares at a certain time and price in the future.
  9. Options & Futures

    Circumvent Limitations of Black-Scholes Model

    Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-09, which was attributed to the flawed use of trading models. ...
  10. Retirement

    Don't Make These Top 10 Mistakes On Your Roth IRA

    Don't lose out on the benefits of a Roth by contributing too much, breaking rollover rules or making other avoidable errors.

You May Also Like

Hot Definitions
  1. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. 2. A situation where sellers have ...
  2. Wash Trading

    The process of buying shares of a company through one broker while selling shares through a different broker. Wash trading ...
  3. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage opportunities in interest rate securities. When using a fixed-income ...
  4. Venture-Capital-Backed IPO

    The selling to the public of shares in a company that has previously been funded primarily by private investors. The alternative ...
  5. Merger Arbitrage

    A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless ...
  6. Market Failure

    An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers ...
Trading Center