Risk reversals as a window into positioning

[Fairman]

Risk reversals as a window into positioning

A risk reversal is the difference in implied volatility between out-of-the-money calls and puts on a currency. When calls are more expensive than puts, the market pays up for upside protection or speculation. When puts cost more, it pays for downside.

It's a sentiment gauge, available from options data providers and some bank research. A strongly negative reading on EURUSD means the market is positioned for a euro decline.

For spot traders, the reading is informative as a contrarian or confirming indicator. Extreme readings can precede reversals, since positioning becomes crowded. Or they confirm a trend that's still being fed.

It doesn't help with timing. A risk reversal may be extreme for weeks before the move occurs.

Where it's useful for scalpers is in understanding the character of a day's trading. In a market with heavy put demand, a sharp drop can accelerate, since dealers who sold puts hedge by selling the currency as it falls.

It's a context tool, one of several, with no entry signal built in.

Do options-based gauges play any role in the trading routine?