What is a 'Risk Reversal'

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

BREAKING DOWN 'Risk Reversal'

A risk reversal is also known as a protective collar. In a short risk reversal, the strategy involves being short call and long put options to simulate a profit and loss similar to that of the underlying instrument; therefore, a short risk reversal may be referred to as a synthetic short. The opposite is true for a long risk reversal. In a short risk reversal, the investor is obligated to sell the underlying asset at the specified strike price since the call option is written. A short risk reversal strategy typically involves selling a call option that has a higher strike price than the long put option. Moreover, the trade is usually implemented for a credit.

Risk Reversal Mechanics

If an investor is short an underlying instrument, the investor hedges the position implementing a long risk reversal by purchasing a call option and writing a put option on the underlying instrument. Conversely, if an investor is long an underlying instrument, the investor shorts a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying instrument.

Commodities Risk Reversal Example

For example, say Producer ABC purchased an $11 June put option and sold a $13.50 June call option at even money; the 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.

Foreign Exchange Options Risk Reversal Example

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 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 convey information to make trading decisions.

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