Risk reversal: trade volatility skew

By roma, 21 August, 2020

Option strategy risk reversal is designed to trade the volatility skew and is formed by buying OTM put option and selling OTM call option. This strategy protects investor from a fall in the price of the underlying asset, but also limits the potential profit when the asset rises in value. Read more about the volatility skew in the article “What is the volatility skew?”.

 

Example

Suppose the Colgate-Palmolive share price is $60. The investor purchased a put option with a strike price of $55 and sold a call with a strike price of $65. Thus, the investor is protected from the share price falling below $55, but will suffer losses if the share price moves above $65.

Professional traders at banks and market makers use the value of Risk Reversal strategy to detect the volatility skew. The difference between the implied volatility of OTM put and OTM call serves as an indicator of investors' concerns about the short-term price movement of the underlying asset. Volatility skew trading is one of the basic strategies of option traders. More details on the practical side of volatility skew trading can be found in the article “Volatility skew trading rules”.

Risk reversal