Risk reversals can be used in a number of situations. They are sometimes in the form of delta hedging, when an investor wants to protect assets from downside risks in price. He wants to buy a put. If he is okay with limiting his upside potential on the starting asset, it’s possible to sell a call to finance the purchase of the put. It is thusly possible to create a position at no initial cost, one that is protected from major downside price movements.
Risk reversals are basically a put of a strike traded against a call of a higher strike. So a 95/105 risk reversal means that 95 puts are bought and 105 calls are sold (or the puts are sold and the calls are bought). More often than not, the put and the call options are out-of-the-money upon initiation of the risk reversal.
Another time someone would consider a risk reversal is as a way to get trading option skew. If the trader things that the ratio of puts to calls is too volatile, it might be smart to consider selling puts to buy calls. That’s a risk reversal. Because a trader will be more interested in the volatility than the dollar values, he will delta hedge the combo (another term for risk reversal) when executed as a skew play. In this way, the delta hedge serves the risk reversal as a way to focus the exposure to volatility. Delta hedging options, lest we forget, means the strategy hinges on volatility instead of directional movement.
Here’s an example of when a trader would price a risk reversal as a skew trade, making him more interested in the implied volatility levels. If his model uses volatility levels of 25 percent for the put, 20 percent for the call, he will consider whether the put is too high or low. It’s important that his model is very accurate in terms of implied volatility.
Pricing and managing risk reversal is one of the more difficult option strategies. It helps to select the combo with the put and call at similar levels of vega, gamma, theta, vomma, and vanna. This way, many of them will cancel each other out. This tactic is often used when combos are used as skew trades. The trader can in this way minimize exposure.
from Mark Tuminello http://ift.tt/SuZ9aI – latest post by Mark Tuminello