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Fundamental Trading Strategy: Risk Reversals
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Risk reversals are a useful fundamentals-based tool to add to your mix of indicators for trading. One of the weaknesses of currency trading is the lack of volume data and accurate indicators for gauging sentiment. The only publicly available report on positioning is the “Commitments of Traders" report published by the Commodity Futures Trading Commission, and even that is released with a three-day delay. A useful alternative is to use risk reversals, which are provided on a real-time basis on the Forex Capital Markets (FXCM) news plug-in, under Options. As we first intro­duced in Chapter 7, a risk reversal consists of a pair of options for the same currency (a call and a put). Based on put/call parity, far out-of-the-money options (25 delta) with the same expiration and strike price should also have the same implied volatility. However, in reality this is not true. Senti­ment is embedded in volatilities, which makes risk reversals a good tool to gauge market sentiment. A number strongly in favor of calls over puts indi­cates that there is more demand for calls than puts. The opposite is also true: a number strongly in favor of puts over calls indicates that there is a premium built in put options as a result of the higher demand. If risk rever­sals are near zero, this indicates that there is indecision among bulls and bears and that there is no strong bias in the markets.

What Does a Risk Reversal Table Look Like?

We showed a risk reversal table before in Chapter 7, (Table 7.3), but want to describe it again to make sure that it is well understood. Each of the abbreviations for the currency options are listed, and, as indicated, most risk reversals are near zero, which indicates no significant bias. For USD/JPY, though, the longer-term risk reversals indicate that the market is strongly favoring yen calls (JC) and dollar puts.

How Can You Use This Information?

For easier graphing and tracking purposes, we use positive and negative integers for call and put premiums, respectively, in Figure 9.18. Therefore a positive number indicates that calls are preferred over puts and that the market as a whole is expecting an upward movement in the underlying currency. Likewise, a negative number indicates that puts are preferred over calls and that the market is exacting a downward move in the un­derlying currency. Used prudently, risk reversals can be a valuable tool in judging market positioning. While the signals generated by a risk reversal system will not be completely accurate, they can specify when the marker is bullish or bearish.

Risk reversals become quite important when the values are at ex­treme levels. We identify extreme levels as one standard deviation plus or minus the average risk reversal. When risk reversals are at these levels, they give off contrarian signals, indicating that a currency pair is over­bought or oversold based on sentiment. The indicator is perceived as a contrarian signal because when the entire market is positioned for a rise…

Figure 9.19 GBP/USD Risk Reversal Chart

once again a month later to 1.90. We saw another top in the EUR/USD, which later became a much deeper descent.

The next example is the GBP/USD. As can be seen in Figure 9.19, risk reversals do a very good job of identifying extreme overbought and oversold conditions. Buy and soil levels are added to the GBP/USD chart for further clarification of how risk reversals can also be used to time market turns. With the lack of price and volume data to give us a sense of where the market is positioned, risk reversals can be helpful in gauging general market sentiment.

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