Why is 10 delta risk reversal cheaper than 20 delta risk reversal? (U are long the risk reversal…)
10 deltas are further OTM (out of the money) strangles – whose puts and calls are cheaper compared to 20 deltas which are closer to ATM.
I’m confused on this as well. In the BB on page 277-78, the answer suggests a long 10-delta Risk Reversal is cheaper than a long 25-delta Risk reversal. I understand the premiums on the the 10-delta RR are smaller b/c they are further OTM. But we are shorting the put to offset the cost of the call. So yes, the 10-delta option premium is smaller. But doesn’t the 10-delta put that you sold also carry a smaller premium than the 25-delta put? So you pay less but receive less from the put sold. Or you could say the 25-delta call costs more, but is offset by a higher premium from the 25-delta put (relative to the 10-detla).
To me, it would seem like the net of each Risk Reversal costs the same.
What am I missing?
I assume it has to do with the skew.
Further OTM puts are increasingly more expensive relative to equi-distance OTM calls.
With a risk reversal, moving from 25-delta to 10-delta on the call side, you may reduce your call option price by X, but moving from 25-delta to 10-delta on the put side, you reduce your put premium received by more than than X, effectively lowering the risk reversal net cost.
I think I follow you… but I think the 2nd paragraph was maybe worded wrong… the put carriees a higher premium than its corresponding call, so shorting the put lowers total cost?
And what’s the logic why puts are more expensive?
You are correct. 2nd paragraph should read “you reduce your put premium by “less” than X” therefore collecting a higher put premium, therefore paying less for the risk reversal.
So why is there a skew in the puts? Because things crash to the downside (not really to the upside) so premium sellers of puts require higher relative protection. The skew, I believe, emerged after the 1987 crash. Before that, people didn’t really know about it. I’m kind of an options geek, but you can correct me if I’m wrong again 