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Risk Reversal

Candlefocus Editor
Risk reversal is a type of hedging strategy used by traders to eliminate unwanted risk due to an unfavorable price movement. The risk reversal strategy is constructed by writing a call option and buying a put option (if long the underlying asset) or buying a call option and writing a put option (if short the underlying asset).

In an FX trading environment, the risk reversal is also referred to as the difference in implied volatility between call and put options. This differs in that the difference in implied volatility is calculated by subtracting the implied volatility of the put option from the implied volatility of the call option.

The purpose of risk reversal is to protect against unfavorable market conditions, giving traders the ability to limit their downside risk without giving up the opportunity to benefit from a favorable market environment. For example, a trader holding a long position in a stock might use a risk reversal to limit their downside risk if the stock price were to drop significantly.

In essence, risk reversal is an advanced hedging strategy that seeks to capture gains while limiting potential losses. However, it should be noted that the risk reversal strategy does not provide the same level of protection against losses as a traditional hedging strategy. Therefore, traders should weigh the pros and cons before adding a risk reversal to their trading strategy.

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