What it means
The classic trading version is simple. An investor who is bullish on a share buys a call option above the current price and pays for it by selling a put option below the current price.
The money from the put offsets the cost of the call, so the position often costs nothing up front. The cost is that the investor takes on downside risk.
If the share price drops below the put's strike price, they may have to buy the shares at that higher strike. The upside is a gain if the price rises above the call's strike, which is why traders call it a way to get cheap bullish exposure.
The same structure can be turned around for protection. A holder of shares may sell a call above the market and use the proceeds to buy a put below the market, creating a collar that limits both losses and gains.
Companies use similar structures in currency hedging to protect a budget exchange rate at low cost. In currency markets, the term has a second meaning.
The risk reversal quote is the difference between the implied volatility of a call and a put with the same sensitivity, for example the 25-delta call minus the 25-delta put. A positive number shows that the market is paying more for upside protection, and a negative number shows it is paying more for downside protection.
A nuance is that the strategy is not free of risk, just free of upfront cost. The investor is still exposed to large losses if the market moves against them, so position sizes need careful limits.
Brokers also quote risk reversals for standard maturities such as one month or three months. By tracking how the number moves, traders judge whether sentiment about a currency or share is improving or worsening.
It is a favourite gauge of market fear in foreign exchange.
In practice
Real-world examples.
Example
A trader expects a retailer's shares to rise after earnings. She buys a call and sells a put at no net cost, accepting the risk that the shares might fall.
Example
A company that imports machinery needs euros in six months. Its treasurer buys a call on euros and sells a put at a different rate, giving a zero-cost range of exchange rates.
Example
A currency analyst reads that the risk reversal on a currency pair has moved sharply negative. She interprets it as the market paying more to protect against a fall in that currency.
Formula
Calculation
Bullish risk reversal profit at expiry = Call Payoff - Put Payoff (the sold put's loss) + Net Premium
Worked example: A share trades at $100. An investor buys a $110 call for $3 and sells a $90 put for $3, so the net premium is $0. One contract covers 100 shares.
If the share ends at $120: the call earns $120 - $110 = $10 per share and the put expires worthless. Profit = $10 x 100 = $1,000.
If the share ends at $100: both options expire worthless. Profit = $0.
If the share ends at $80: the call expires worthless and the put loses $90 - $80 = $10 per share. Loss = $10 x 100 = $1,000.
For the market measure, if the 25-delta call has an implied volatility of 8.5% and the 25-delta put has 9.5%, the risk reversal is 8.5% - 9.5% = -1.0 volatility point.
If the bullish trade had instead cost a net $1 per share, the break-even on the upside would be $110 + $1 = $111, and the downside loss would begin at $90 with an extra $1 cost. The zero-cost structure simply removes that extra cost.Case study
Seen in the real world.
Marlow Components is a fictional exporter that expected to receive 5,000,000 foreign currency units in six months. In this illustrative case, the treasurer was worried the currency would weaken but wanted to keep some benefit if it strengthened.
She bought a put at a floor rate and sold a call at a higher ceiling rate, so that the premium received matched the premium paid. This gave the company a guaranteed minimum rate and a capped maximum, and the budget could be built around that range without any upfront cost.
At the end of the six months the currency had weakened, so the floor protected the receipts. The treasurer reported that the structure delivered the minimum rate in the budget, even though the company gave up some gains it would have had if the currency had strengthened.
Watch out
Common mistakes.
- Treating a zero-cost structure as risk-free. The sold option can still lose a lot of money.
- Ignoring the capped gains in a hedging risk reversal. The company gives up benefit beyond the strike it sold.
- Mixing up the two meanings. One is a trading strategy, and the other is a quoted measure of volatility skew.
Questions
People also ask.
What is a bullish risk reversal?
It involves buying a call and selling a put, which profits if the price rises and loses if it falls sharply.
Why is it often zero cost?
The premium from the option sold is chosen to cover the premium of the option bought.
What does a negative risk reversal quote mean?
Puts are more expensive than calls, which suggests the market is more worried about falls than rises.
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