What is a Risk Reversal?
Risk reversals are useful indicators based on fundamentals, which we can use and multiple indicators in trading. The most vulnerable part of FX trading is that there are no accurate indicators to identify trading volume data and market sentiment. The only material available for market participants is the COT(Commitment of Trade) report from the U.S. CFTC(Commodity Exchange Commission).
The risk reversal indicator is consists of call options and put options for the same currency. This means the volatility difference between the underlying spot exchange rate with the same sensitivity (meaning options with the same delta value) and the call/put option with maturity.
For example, if the call option with a delta value other than one-month maturity is 0.25 and the put option is 0.20, the risk-reversal is 0.25-0.20 = 0.05. This is because the demand for call options is more significant than that for put options. The inherent volatility of the call is greater than that of put options, which the market expects to see a rise in prices.
Theoretically, the call and option must have the same intrinsic volatility, but it does not match the real world. Inherent volatility refers to volatility calculated by substituting an option’s price in a pricing model, whereas historical volatility refers to volatility calculated from historical price data.
If the call is very advantageous in these figures (call volatility > put volatility), it is shown that the market prefers the call option to the put option. Conversely, if the put option is very advantageous in this figure, the put option is chosen in the market (put volatility > call volatility). Thus, the risk-reversal figures suggest the market position (overbuying or overselling).
Take Advantage of Option Volatility
Many hedge funds prefer option volatility data because it helps them gain a more in-depth and more precise picture of the market. Inherent volatility is a measure of exchange rate change expected over a given period based on past exchange rate changes.
This is usually calculated from the annual standard deviation data for daily price changes. Futures prices help calculate inherent volatility and are also used to calculate option premiums. Although these may seem somewhat difficult, utilising option volatility is not very complicated.
The volatility of an option is to measure the extent of currency price changes over a given period based on historical variable data. Therefore, short-term volatility is significantly reduced compared to long-term volatility if the daily average range of variation is reduced from 100 to 60 and is maintained for about two weeks.
Thus, if EUR/USD shows 100 to 60 daily variations and stays in this range for about two weeks, daily/short-term volatility also narrows to exactly this range compared to weekly/long-term fluctuations over the same period.
Principles of Option Volatility
1. If the short-term option volatility is lower than the long-term option volatility, the direction is uncertain, but it should be expected to break through the existing range.
2. If the short-term option volatility is higher than the long-term option volatility, it means that regression to the existing range is likely to occur.
This principle is established because the inherent option volatility is lower when the exchange rate moves within the range. We should be most careful when option volatility drops sharply because this time may be on the verge of a breakthrough.
Risk Reversal Strategy helps traders who use the breakthrough strategy as it helps them predict potential breakthrough points. After checking the past range, traders should look at option volatility to determine whether the exchange rate will stay in the range.
Monitoring option volatility will help them to decide when to liquidate positions. If short-term option volatility falls below long-term volatility, traders should consider selling price if the breakthrough does not occur.