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Lesson on risk reversal positions

I was reading a Reuters article this morning, and they mentioned how euro risk reversals are at a 6-month high, presumably because hedge funds are shorting the euro. For the sake of news, the euro has been unable to break the $1.4500 mark lately, and is at $1.4169 after dropping 271 pips today (.0271 percentage points). Good news for those who think the Fed is trying to inflate away our debts, I’ll be doing a post on that bullshit sometime soon (basically people who think that are fuckin’ morons). BUT, just reading that one headline I realized I have no idea what a risk reversal is for. So, I did some fuckin’ readin’ and now I know what it is. And because I took the time to read up on what they’re used for… I’m gonna spread some god damn knowledge on ya ass. For clarity, I’m gonna explain it as if my friend, Petrone, is bullish on Microsoft stock (he heard they bought Skype and thinks they’re gonna gain like 20 fuckin’ points or some shit).

So, Petrone hears about the Skype buyout and gets all excited about Microsoft stock. It’s at about $24/share, but let’s assume it’s $50/share for this example. Petrone thinks Microsoft is gonna enjoy a big rally and wants to go long the stock. But, he doesn’t just wanna have a straight-up position in a market as uncertain as today’s. So instead of just buying the stock for $24/share, he’s going to enter into 2 option contracts, this is the risk reversal strategy.

First, a quick refresher on the options he’ll buy. Petrone will go long a call option. Buying a call option means you pay a premium (say $5) for the right to buy the underlying (MSFT stock in this case, $50 right now) at a specified future price, the strike price (say $60), at or before the expiration date (say 1 year). If you are the buyer of the option you don’t have to purchase the underlying, you just pay the premium for the right to purchase it before the contract expires. So, when Petrone is long a call option, he’s hoping the underlying current stock price (spot) will be greater than the strike price before the option expires. If that’s the case, he can turn around and sell the stock he just bought for the market/spot price. If the difference between the spot and strike is greater than the premium he paid, then he’ll make a profit. In our example, if MSFT is worth $70/share at some point before the expiration, Petrone will make a profit of $5 ($70-$60-$5=$5) if he exercises the option at that point. He pays the premium when purchasing the option and the strike price when exercising the option, then sells the asset at the market/spot price and hopefully profits.

Now, in the case of a risk reversal, Petrone is going to short a put option before he’s does the above. Much like buying a call option, shorting a put option means Petrone thinks MSFT’s spot price will rise in the future. Again, the buyer of a put option pays a premium (say $5) for the right to sell an underlying asset to the seller of the option, Petrone, at the strike price (say $40). So, the buyer is hoping the spot price will fall below the strike price by at least the value of the premium, because then he’ll be selling the stock at a strike that’s higher than the market/spot price and will profit. In Petrone’s case, he’s going to be the seller of the put option, so he’s hoping the spot price stays above the strike price (the buyer of the put option won’t exercise the option, and Petrone will make a profit of $5, the premium).

The reason Petrone shorts a put option first, is so he can use the premium he earns from it, $5, to buy the call option at $5. So, if the spot price is originally $50 and never falls below $40 or rises above $60, neither option will be exercised, and he’ll break even. If the spot rises above $60, then Petrone will exercise the call option and make a profit of the spot minus $60. For instance, if 7 months after he enters both contracts the spot is $70, he’ll make $10 (spot-strike-call premium+put premium; $70-$60-$5+$5=$10). If the spot falls below $40, the buyer of the put he sold will exercise the option, and he’ll lose the amount it falls below $40. For instance, if 7 months later the spot is $30, he’ll lose $10 ($30-$40-$5+$5=-$10).

So, instead of just buying MSFT at a $50 face value, Petrone can make a synthetic long position with both a long call and short put with very little money to begin with ($0 in our example). Risk is reduced big time as you can see, and so is the possible reward. The increased leverage he can use more than makes up for the difference in volatility. If there’s a lot of volatility (spot goes ±$10) there’s a fat possible gain/loss with big leverage, but if there’s low volatility (spot above $40/below $60) there’s very little cost, if any.

Back to the original reason for writing about this, euro risk reversals are at a 6-month high. A high risk reversal means that the call option is more volatile than the put option. In other words, long positions on the euro/dollar are riskier positions than short positions. So, the risk reversal levels are good indicators of where an asset’s price is going, especially on currencies. In this case, the euro is not going to be doing well in the future.

… That probably made no fuckin’ sense.