In finance, risk reversal (also known as a ''conversion'' when an investment strategy) can refer to a measure of the
volatility skew
Volatility smiles are implied volatility patterns that arise in pricing financial option (finance), options. It is a parameter (implied volatility) that is needed to be modified for the Black–Scholes formula to fit market prices. In particular ...
or to a
trading strategy
In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency ...
.
Risk reversal investment strategy
A risk-reversal is an
option position that consists of selling (that is, being short) an
out of the money
In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a thr ...
put and buying (i.e. being long) an out of the money
call
Call or Calls may refer to:
Arts, entertainment, and media Games
* Call, a type of betting in poker
* Call, in the game of contract bridge, a bid, pass, double, or redouble in the bidding stage
Music and dance
* Call (band), from Lahore, Paki ...
, both options expiring on the same
expiration date
An expiration date or expiry date is a previously determined date after which something should no longer be used, either by operation of law or by exceeding the anticipated shelf life for perishable goods. Expiration dates are applied to selecte ...
.
In this strategy, the investor will first form their market view on a stock or an index; if that view is
bullish
Market sentiment, also known as investor attention, is the general prevailing attitude of investors as to anticipated Market trends, price development in a market. This attitude is the accumulation of a variety of fundamental analysis, fundamenta ...
they will want to go long. However, instead of going long on the stock, they will buy an out of the money call option, and simultaneously sell an out of the money put option, using the money from the sale of the put option to purchase the call option. Then as the stock goes up in price, the call option will be worth more, and the put option will be worth less.
[http://www.quantprinciple.com/invest/index.php/docs/quant_strategies/riskreversal/ Theory of Risk Reversal]
A risk reversal position can simulate the profit and loss behavior of owning an underlying security; therefore it is sometimes called a synthetic long. This is an investment strategy that amounts to both buying and selling out-of-money options simultaneously.
Risk reversal (measure of vol-skew)
Risk reversal can refer to the manner in which similar out-of-the-money call and put options, usually
foreign exchange option
In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at ...
s, are quoted by
finance
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
dealers. Instead of quoting these options' prices, dealers quote their
volatility.
:
In other words, for a given maturity, the 25 risk reversal is the vol of the ''25 delta call'' less the vol of the ''25 delta put''. The ''25 delta put'' is the put whose strike has been chosen such that the delta is -25%.
The greater the demand for an options contract, the greater its price and hence the greater its implied volatility. A positive risk reversal means the implied volatility of calls is greater than the implied volatility of similar puts, which implies a 'positively' skewed distribution of expected spot returns. This is composed of a relatively large number of small down moves along with the possibility of few but relatively large up moves.
See also
Investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics an ...
References
Other external links
* Reuters description
{{Derivatives market
Options (finance)