Maybe I’m confused but, in dealing with hedging a foreign currency risk, but I feel like they go back & forth on weather or not a call provides downside protection, versus when the put would provide downside protection…can someone clarify?
thnx,
this might clarify- I am really confused by this statement here:
"In professional FX markets, having a long position in a call option and a short position in a put option is called a risk reversal. For example, buying a 25-delta call and writing a 25-delta put is referred to as a long position in a 25-delta risk reversal. The position used to create the collar position we just described (buying a put, writing a call) would be a short position in a risk reversal.
Can someone help me put this into plain english?
= 50delta is at the money, < 50delta is otm, > 50delta is itm
thry just creating various collars, one upside protection and one for downside
Properly, ≈ 50 delta is at the money. Exactly 50 delta is slightly out of the money.
You don’t need “upside protection”. One is for downside protection, the other gives away upside to pay for it.
Look at it this way - if buy a call and sell a put both with same ATM strike, you are essentially long a forward since you pay nothing and your payoff is that of a forward.
Now move away from ATM strike, and buy a 25-delta call and sell a 25-delta put. Now above 25-delta call and below 25d put you get a linear payoff, between the two it’s flat (generally).
Practically, the risk reversals are a good indicator of the demand of puts and calls in the out of money region. For e.g. in adverse market conditions there will be great demand for puts and less for calls. Risk reversal will indicate this.
RR 25 = 25 delta call - 25 delta put.
Also the 25d and ATM strike are most liquid options. Risk reversals along with butterfly are used to get the important points on the volatility smile.
HTH
thanks! I think I’m there…why exactly is it called a risk-reversal position then?
And if I am long a 25RR- long OTM call, short OTM put…my big Q is- what is this position doing? I just can’t wrap my head around why it isn’t a LONG put sell higher call (like the collar)?
You know what a collar is… u know what a risk reversal is, except it goes backwards.
Long Put + Short Call = Protects from the underlying sliding. If the underlying loses value and this causes losses, you long put offsets the losses.
Short Put + Long Call = Protects from the underling increasing. If the underlying increases in value and this causes losses, your long call offsets the losses.
Why backwards? IT has to do with how your FX works, the depreciation/appreciation. Example:
If you are a UK based company and doing business in MX, you are long the foreign asset. If the MX/UK fx rate goes up (pounds appreciate), you lose money. Therefore, the long call on the pound is your protection!
Yes, I was impling long risk reversal vs short risk reversal — but I didnt write it all out 