What is Risk Reversal options
Definition: The quickest strategy in material trading is to sell a Call and buy a Put option with the same maturity. This strategy protects an investor from unfavourable downward price movements. However, the upside is also limited in case of upward movements. The Puts bought are generally of lower strike prices whereas the Calls sold have higher strike prices.
Description: Risk reversal is done for two reasons – delta hedging or options skew. Delta hedging is primarily done to protect your asset from unfavourable downward price movements. An investor will buy a Put option to protect the downside. However, to finance the purchase of the Put option, the investor also has to sell a Call option. The selling of the Call option, thus, limits the potential upside in case of any upward movement.
For example, a manufacturing organisation known as ABC purchased a Rs 100 June Put option and sold a Rs 130 June Call option at same Put and Call options, which means the premium of Put and Call are equal. Under this scheme, ABC is guarded against all price hikes and downfalls (price fluctuation) in June below Rs 100 but the profit from any price rise will also have a maximum limit of Rs 130.
Options skewing involves quoting of out-of-the-money Calls and Puts. Instead of quoting the prices, dealers quote their implied volatility levels. The greater the demand for a contract, the higher will be the price and also the volatility. Positive reversal will imply the volatility of Calls is greater than that of the Puts and, thus, it would indicate a bullish trend and vice versa.
A check that the trader has to place is what sort of implied volatility levels are suited for Calls and Puts. For example 25 per cent volatility levels may be alright for Calls but may not work out for Puts.
Description: Risk reversal is done for two reasons – delta hedging or options skew. Delta hedging is primarily done to protect your asset from unfavourable downward price movements. An investor will buy a Put option to protect the downside. However, to finance the purchase of the Put option, the investor also has to sell a Call option. The selling of the Call option, thus, limits the potential upside in case of any upward movement.
For example, a manufacturing organisation known as ABC purchased a Rs 100 June Put option and sold a Rs 130 June Call option at same Put and Call options, which means the premium of Put and Call are equal. Under this scheme, ABC is guarded against all price hikes and downfalls (price fluctuation) in June below Rs 100 but the profit from any price rise will also have a maximum limit of Rs 130.
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Options skewing involves quoting of out-of-the-money Calls and Puts. Instead of quoting the prices, dealers quote their implied volatility levels. The greater the demand for a contract, the higher will be the price and also the volatility. Positive reversal will imply the volatility of Calls is greater than that of the Puts and, thus, it would indicate a bullish trend and vice versa.
A check that the trader has to place is what sort of implied volatility levels are suited for Calls and Puts. For example 25 per cent volatility levels may be alright for Calls but may not work out for Puts.