What is a Risk Reversal?

Risk reversal is a term that can be used to refer to two different situations within the investing process. When used in reference to the trading of commodities, the term identifies a type of strategy that involves buying a put option while also selling a similar call option. As it relates to foreign exchange trade activities, risk reversal is defined by the relationship between the put and call options involved. With foreign exchange or FX trading, the reversal may be interpreted as positive or negative.

One of the best ways to understand how risk reversal works when trading commodities is to assume that an investor chooses to purchase a put option while also selling a call option for a slightly higher price. Assuming that the premiums on the two transactions are similar, this creates a situation in which the investor does not have to be concerned about any decreasing price moves that would fall below the price of the put option. At the same time, the investor stands to benefit from any upward movement that that is more than the put option price but less than the call option price. While the profits that can be earned from this arrangement are limited by the price of the call option, many investors see this as an effective way to prevent incurring a loss, and are comfortable with the modest opportunity for increasing the return.

As it relates to FX trading, the risk reversal addresses the amount of risk or volatility that is present with a specific set of put and call options. Here, the goal is to determine if the projected movement of the options contract involved will result in a negative or positive reversal. If there is a high demand for the options contract, the volatility increases as the price increases. With a positive risk reversal situation, the volatility of the call option is higher than the volatility of the put option. If the put option risk is higher than the call option risk, then the contract is said to carry negative risk reversal.

In both settings, the value of calculating risk reversal is that investors can use the data to help them make informed investment decisions. With a commodity trade, the investor can determine if the difference between the put and call options will generate enough potential for a desirable amount of profit, given the decreased amount of risk involved. With foreign exchange trades, identifying the nature of the risk reversal makes it possible to gauge whether the trade is likely to produce the results desired by the investor; if not, then the deal can be avoided and the investor can consider other options.