Long (short) risk reversal strategy

Volatility smile and volatility skew

Holding expiration date constant, there are two often-observed patterns in the relationship between implied volatility and strike price:

• A volatility smile is where the further-from-ATM options have higher implied volatilities, so we would see a U-shaped (smiling) curve if implied volatility were plotted against strike. This shape is less common compared to the volatility skew, which we discuss next.
• A volatility skew is where implied volatility increases for more OTM puts, and decreases for more OTM calls. This is explained by OTM puts being desirable as insurance against market declines (so their values are bid up by higher demand, and higher values implied higher volatility), while the demand for OTM calls is low.

Deviations in the skew from historical levels can be used to draw conclusions about market sentiment:

• A sharp increase in the level of the skew, plus a surge in the absolute level of implied volatility, is an indicator that market sentiment is turning bearish.
• Higher implied volatilities (relative to historical levels) for OTM calls indicate that investors are bullish, so the demand for OTM calls to take on upside exposure is strong.

These are the kinds of temporary deviations that risk reversals strategies try to exploit.

Risk reversal strategy example

Let’s consider an example. Imagine a trader believes that put implied volatility is relatively too high, compared to that for calls. In that case, a long risk reversal could be created by: 

• buying the OTM call (seen as relatively underpriced) and 
• selling the OTM put (seen as relatively overpriced)

Both options would have the same expiration. This would create a broadly long exposure to the underlying, which would be problematic. The positive exposure comes from the positive delta from the long call and the short put.