July 2001

Financial Derivatives

Trading and Hedging Options

July 2001

S.K.Kang

July 2001

Financial Derivatives

Table of Contents

S.K.Kang

Section 1

Option Risks

Section 2

Option Trading Strategies

Section 3

Risk Reversal

Section 4

Summary

July 2001

Financial Derivatives

Section 1

Option Risks

S.K.Kang

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Similarities in hedging between
options and a coin-tossing
game in a casino
Self financing
Replicating
Dynamic

Naked Hedging
This is not sitting at the trading desk without wearing a tie
Naked hedging is a nave method of hedging, based on a simple principle: An
option will only be exercised if, on maturity, it is in-the-money
No hedge is maintained when the option is OTM and 100% is hedged when
ITM, all hedging being done at the strike price
This method is usually employed by writers who hope to profit by the entire
premium received. Options are sold as OTM and only hedged when the
underlying price crosses the strike price
This method can be successful (a) when the underlying price never
approaches the strike, and (b) when the underlying price goes through the
strike (100% hedge transacted) and stays ITM without recrossing the strike
One can be lucky with this simple approach, but the underlying price could
easily cross and re-cross the strike several times
Trader may even have some sleepless nights when the underlying price just
sits on the strike

S.K.Kang

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Call option:
Current underlying price $99
Strike $100
Volatility 15%
Expiry 1 year
Interest rate 0%
Delta 0.50

S.K.Kang

Performance of Option versus Underlying

Underlying portfolio (Long 50)
Underlying Underlying value
Change in
price
= 50 x price
Underlying value
93.0
4,650
(300)
94.0
4,700
(250)
95.0
4,750
(200)
96.0
4,800
(150)
97.0
4,850
(100)
98.0
4,900
(50)
98.9
4,945
(5)
99.0
4,950
0
99.1
4,955
5
100.0
5,000
50
101.0
5,050
100
102.0
5,100
150
103.0
5,150
200
104.0
5,200
250
105.0
5,250
300

Difference
Option portfolio (Long 100)
Option
Option value
Change in
Outperformance of
price
= 100 x price Option value Option over Underlying
2.93
293
(253)
47
3.28
328
(218)
32
3.67
367
(179)
21
4.07
407
(139)
11
4.51
451
(95)
5
4.97
497
(49)
1
5.41
541
(5)
0
5.46
546
0
0
5.51
551
5
0
5.98
598
52
2
6.52
652
106
6
7.09
709
163
13
7.69
769
223
23
8.30
830
284
34
8.95
895
349
49

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
The P/L line of the short
underlying position is
displayed as a positive
sloping line but in reality it is
negative.

Performance of Option versus Underlying

400
Underlying portfolio
Option portfolio

300

Illustrated this way, the net

profit is simply the
outperformance measure in
the previous page.

Net profit

200

Profit from
long 100 options

Profit ($)

100

Loss from short

50 underlyings

93

94

(100)
Loss from
long 100 options

95

96

97

98

99

100

101

102

103

104

105

Profit from short

50 underlyings

(200)
Net profit

(300)

(400)
Underlying price ($)

S.K.Kang

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Long Gamma Trade
Start with a position that is initially market neutral but that gets long if the
market rises and gets short if the market falls
Long 100 options and simultaneously short 50 underlyings
Small Underlying Price Moves
Market neutral or delta neutral

The fact that, in the future, an

option may be worth
something or nothing, and
that just one price delineates
the boundary between these
two states, gives rise to the
current price being curved.

Large Underlying Price Moves

A curved price profile gives

rise to a constantly changing
exposure to whatever
underlies the option.

If the underlying price rises, the exposure of the option increases above the
constant exposure of the short underlying position and so the total portfolio
automatically becomes long

S.K.Kang

Whichever way the underlying price moves, we always make a profit

The essence of the long gamma trade
The trade works simply because of price curvature and the price profile is
only curved because of the kink on expiry

July 2001

Option Risks

Financial Derivatives

Dynamic Hedging
How to lock in the profits
If the first significant move is up $6 to $105, we have our first mark-tomarket paper profit of $49
The simplest way of locking this profit is to completely liquidate (Sell the
options and buy back the short underlyings)
However, there may be still more profit to be made out of the position
Rehedging process locks in the profit and sets up a situation in which further
profits can be made
To be market neutral again, long 100 options and short 66 underlyings by
selling further 16 underlyings (At $105 the delta is 0.66)
at $99 -5.46x100 + 99x50
at $105 8.95x100 - 105x50
-8.95x100 + 105x66
at $99 5.46x100 - 99x66
-5.46x100 + 99x50

+49
+47

If the underlying price moves from $99 to $105 and back to $99, we sell 16
shares at $105 and buy them back at $99 giving a profit of 16 x (105-99) = $96
$49 profit made in moving from $99 to $105 and $47 in moving from $105
back to $99
The rehedging process forces us always to be in the position of buying low
and selling high

S.K.Kang

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Effect of Time Decay

It is not possible to end up with a situation that will always yield a profit
As time passes an option suffers time decay or theta decay
The very options that have little or no time decay (deep OTM or ITM
options) also have very little price curvature
The near-the-money options suffer the most time decay
Options with the most curvature unfortunately suffer the most time decay
800

For the trade to break even, the

price has to move as far $106
in the 3 months

Underlying portfolio
Option with 12 months to expiry
Option with 9 months to expiry

600

Profit ($)

400

200

91

93

95

97

99

101

103

105

107

109

111

(200)

(400)

(600)

S.K.Kang

Underlying price ($)

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Effect of Time Decay

The bleed is the change in the

delta and the gamma of an
option position with the
passage of time.

Time Decay Effects on Delta and Gamma

As time passes:

Delta bleed = Delta today

Delta next day
Gamma bleed = Gamma
today Gamma next day

This also shows

the effect of falling
volatilities on
Delta and Gamma

The sensitivity of option prices

to changes in volatility is
similar to the sensitivity to
time. Near-the-money
options are most sensitive
and deep OTM / ITM options
are less sensitive.

OTM

ATM

ITM

Delta
Gamma

Vega Effects on Delta and Gamma

Falling volatilities will have a similar effect to that of time passing

Shorter-dated options have

lower vegas.

S.K.Kang

With increasing volatilities the effects are the reverse

10

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Frequency of Rehedging
No rehedging will mean no rehedging profits
We will actually suffer losses due to option time decay
Rehedging more frequently will capture profits due to small price swings but
has the disadvantages of missing out on the really large profits obtained with
large price swings
Two points to consider are the costs of rehedging and the likely time decay
The chosen rehedging strategy will be a question of compromise

S.K.Kang

11

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Importance of Curvature - Gamma

One can achieve the same rehedging profit with a smaller underlying price
move using an option with a more marked degree of curvature.
Gamma is the change in delta associated with a change in price of the
underlying
Gamma is a measure of the rate at which we rehedge a delta neutral
position
High gamma options provide more rehedging profits
Gamma is a direct measure of the potential profit due to a change in price
of the underlying
Long gamma refers to the fact that the gamma of the position is positive

S.K.Kang

12

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
If an option is delta hedged
efficiently on each movement
of the underlying price, and
the actual volatility
experienced over the life of
the option is the same as that
used to calculate the original
premium, then the delta
hedge losses of the option
seller will equal the original
premium received

An Alternative View on Option Fair Value

The idea behind the long gamma trade is to capitalize on future volatility in
the underlying price.
If the option is cheap enough and/or the future volatility is high enough, a
profit results. The strategy generates profits by buying underlying low and
selling high and the overall trade produces a net positive profit if these
rehedging gains exceed the time decay losses.
Short Gamma Trade
Selling low and buying high is a direct result of the fact that the position is
short gamma
Losses will be smaller than those suffered without rehedging
Hedge is used to reduce or remove directional risk
Trade will generate a net profit if the effects of time passing and/or volatility
falling exceed the cost of rehedging

S.K.Kang

13

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Vol traders trade vol

Long Options

Short Options

Every option is spot

sensitive
Delta hedge (any traded
option is spot hedged)

Original
Position

Market conditions
change

Long Call

Long Put

Short Call

Short Put

1st Hedge
Sell

1st Hedge
Buy

1st Hedge
Buy

1st Hedge
Sell

Sell

Buy

Buy

Delta changes (Gamma)

Adjust the delta hedge

Underlying
Price Move
Delta
Adjustment

Sell

Buy

Buy

You earn money

through adjustments
S.K.Kang

Sell

Sell

You lose money

through adjustments
14

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Monitoring Option Risks

Long 100 calls

vol shift = 1%
time shift = 1 day
underlying price shift = $0.10
At $99:
Delta = (5.512418-5.461963)/0.10
Vega = 5.856885-5.461963
Theta = 5.453842-5.461963
Gamma = 0.50723-0.50455

Long 100 calls + short 50

underlyings
The only difference is in the
EUP and P&L
Since the underlying has no
price curvature or gamma, the
theta risk and vega risk are
unaffected
The sensitivity of an options
portfolio will be the sum of the
individual sensitivities

S.K.Kang

Profit and loss ($)

P&L
P&L
(+vol)
(+time)
(413)
24
(0.50)
(369)
28
(0.57)
(316)
31
(0.64)
(253)
34
(0.70)
(179)
37
(0.75)
(95)
38
(0.79)
0
39
(0.81)
106
40
(0.82)
223
40
(0.81)
349
39
(0.79)
485
37
(0.76)
629
35
(0.72)
781
33
(0.68)

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
20
0.21
24
0.23
29
0.25
34
0.26
39
0.27
45
0.27
50
0.27
56
0.26
61
0.25
66
0.23
70
0.22
74
0.20
78
0.18

Profit and loss ($)

P&L
P&L
(+vol)
(+time)
187
24
(0.50)
131
28
(0.57)
84
31
(0.64)
47
34
(0.70)
21
37
(0.75)
5
38
(0.79)
0
39
(0.81)
6
40
(0.82)
23
40
(0.81)
49
39
(0.79)
85
37
(0.76)
129
35
(0.72)
181
33
(0.68)

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
(30)
0.21
(26)
0.23
(21)
0.25
(16)
0.26
(11)
0.27
(5)
0.27
0
0.27
6
0.26
11
0.25
16
0.23
20
0.22
24
0.20
28
0.18

Underlying
price
87
89
91
93
95
97
99
101
103
105
107
109
111

P&L

Underlying
price
87
89
91
93
95
97
99
101
103
105
107
109
111

P&L

15

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Summary of Greeks

Long underlying
Short underlying
Long call
Short call
Long put
Short put
Delta
positive
negative
Gamma
positive
negative
Theta
positive
negative
Vega
positive
negative
S.K.Kang

Delta
(hedge ratio)
positive
negative
positive
negative
negative
positive

Gamma
(curvature)
0
0
positive
negative
positive
negative

Theta
(time decay)
0
0
negative
positive
negative
positive

Vega
(volatility)
0
0
positive
negative
positive
negative

you want the underlying contract to

rise in price
fall in price
you want the underlying contract to
move very swiftly, regardless of direction
move slowly, regardless of direction
the passage of time will generally
increase the value of your position
decrease the vlue of your position
you want volatility to
rise
fall
16

July 2001

Financial Derivatives

Option Risks

Dynamic Hedging
Graphing Positions

positive theta graph shifts

upward over time
negative theta graph shifts
downward over time

positive delta
(graph extends from lower
left to upper right)

negative delta
(graph extends from upper
left to lower right)

positive (negative) vega

graph shifts upward with
higher (lower) volatility
negative (positive) vega
graph shifts downward with
higher (lower) volatility

positive gamma
(a smile)

S.K.Kang

negative gamma
(a frown)

17

July 2001

Financial Derivatives

Section 2

Option Trading Strategies

S.K.Kang

18

July 2001

Financial Derivatives

Option Trading Strategies

4 Basic Trading Positions

What is a typical long gamma trading?
View: Nervous market with frequent moves (e.g., event periods)
Position: Long short term options (i.e., with high gamma and low vega)
Result: Position is more spot than vol sensitive
Frequent delta adjustments are needed
The trader trades spot!
What is a typical long vega trading?
View: Spot reaches new trading ranges
Long known trend is about to reverse
Position: Long long term options (i.e., with high vega and low gamma)
Result: Position is more vol than spot sensitive
Only few delta adjustments should be needed
The trader trades vol!
S.K.Kang

19

July 2001

Option Trading Strategies

Financial Derivatives

4 Basic Trading Positions

Long Gamma
Long Vega

Short Gamma
Long Vega

Long Gamma
Short Vega

Short Gamma
Short Vega

Long
short term
options

Short
short term
options

Long
short term
options

Short
short term
options

Long
long term
options

Strong trend with

important corrections

S.K.Kang

Long
long term
options

Stable market with

long term risks

Short
long term
options

Usually stable
markets with punctual
nervousness

Short
long term
options

Calm after storm

20

July 2001

Financial Derivatives

Option Trading Strategies

Volatility Spreads
Time Spread

4.5

Long Time Spread

4

- long 12m 100 call

3.5

* Long-dated options do suffer

time decay, but at a slower
rate than short-dated ones
Near-the-money:

Long Time Spread price ($)

- short 6m 100 call

2.5
2

1.5
1

12m to expiry
8m to expiry
7m to expiry
6m to expiry

Delta neutral
0.5

Negative gamma
Positive theta

0
80

Positive gamma
Negative theta

S.K.Kang

90

95

100

105

110

115

120

Underlying price ($)

Positive vega
Deep OTM / ITM:

85

Underlying
price
75
79
83
87
91
95
99
103
107
111
115
119
123

Profit and loss ($)

P&L
P&L
P&L
(+vol)
(+time)
(161)
5
(0.09)
(145)
8
(0.12)
(119)
11
(0.12)
(84)
13
(0.04)
(47)
13
0.10
(17)
12
0.25
0
12
0.34
(1)
12
0.32
(17)
13
0.21
(42)
15
0.08
(71)
15
(0.05)
(99)
14
(0.13)
(122)
12
(0.16)

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
3
0.05
5
0.06
8
0.06
9
0.02
9
(0.04)
6
(0.09)
2
(0.11)
(2)
(0.10)
(5)
(0.06)
(7)
(0.02)
(7)
0.01
(6)
0.03
(5)
0.03

21

July 2001

Financial Derivatives

Option Trading Strategies

Volatility Spreads
Strangle

Short Strangle

80

- short 12m 110 call

85

90

95

100

105

110

115

120

-2

- short 12m 90 put

Delta neutral
Negative gamma
Positive theta
Negative vega

Short Strangle price ($)

-4

-6

-8
12m to expiry
6m to expiry
3m to expiry
1m to expiry
expiry

-10

-12

-14
Underlying price ($)

Underlying
price
87
89
91
93
95
97
99
101
103
105
107
109
111
S.K.Kang

Profit and loss ($)

P&L
P&L
(+vol)
(+time)
(283)
(46)
0.94
(192)
(50)
1.03
(119)
(54)
1.11
(63)
(57)
1.17
(25)
(60)
1.23
(4)
(62)
1.27
(0)
(63)
1.30
(14)
(64)
1.31
(45)
(64)
1.32
(91)
(64)
1.31
(153)
(63)
1.28
(230)
(61)
1.25
(320)
(59)
1.21

P&L

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
49
(0.40)
41
(0.42)
32
(0.43)
24
(0.44)
15
(0.44)
6
(0.44)
(3)
(0.43)
(11)
(0.42)
(19)
(0.40)
(27)
(0.38)
(35)
(0.36)
(42)
(0.34)
(48)
(0.32)

22

July 2001

Financial Derivatives

Option Trading Strategies

Volatility Spreads
Characteristics of Volatility Spreads

Volatility spread need not be

exactly delta neutral.
A practical guide is for the
delta to be close enough to
zero so that the volatility
considerations are more
important than the
directional considerations.

Volatility Spread Type

Backspread
Long Straddle
Long Strangle
Short Butterfly
Ratio Vertical Spread
Short Straddle
Short Strangle
Long Butterfly
Long Time Spread
Short Time Spread

Delta
0
0
0
0
0
0
0
0
0
0

Gamma
+
+
+
+
+

Theta
+
+
+
+
+
-

Vega
+
+
+
+
+
-

* Call back spread long more calls at a higher strike (K) than short calls at a lower K
Put back spread long more puts at a lower K than short
Call ratio vertical spread short more calls at a higher K than long
Put ratio vertical spread short more puts at a lower K than long
Long straddle long call and put at the same K
Short straddle short call and put at the same K
Long strangle long put (call) at a lower K and call (put) at a higher K
Short strangle short put (call) at a lower K and call (put) at a higher K
Long butterfly short two calls (puts) at a middle K, long one call (put) at a lower K and one at a higher K
Short butterfly long two calls (puts) at a middle K, short one call (put) at a lower K and one at a higher K
Long time spread long a long-term option and short the same type short-term option at the same K
Short time spread short a long-term option and long the same type at the same K
S.K.Kang

23

July 2001

Financial Derivatives

Option Trading Strategies

Directional Trade
Vertical Spreads

Bull Spread

10
9

12m to expiry
6m to expiry
3m to expiry
1m to expiry
expiry

8
7
Bull Spread price ($)

If a trader focuses initially

on the direction of the
underlying market, he might
look for a spread where the
directional characteristics of
the spread are the primary
concern, and volatility is of
secondary importance

6
5
4

- long 12m 100 call

- short 12m 110 call

2
1

Lower Region:

0
80

85

90

(like a long call)

Positive vega
Upper Region:
(like a short put)
Negative gamma
Positive theta
Negative vega

S.K.Kang

100

105

110

115

120

125

Underlying price ($)

Positive gamma
Negative theta

95

Underlying
price
87
89
91
93
95
97
99
101
103
105
107
109
111

Profit and loss ($)

P&L
P&L
(+vol)
(+time)
(228)
13
(0.26)
(200)
13
(0.27)
(168)
13
(0.27)
(131)
13
(0.26)
(91)
11
(0.23)
(47)
9
(0.19)
(0)
7
(0.14)
48
4
(0.09)
98
1
(0.02)
148
(2)
0.04
197
(5)
0.11
245
(8)
0.17
291
(11)
0.23

P&L

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
13
0.11
15
0.11
17
0.11
19
0.10
21
0.08
23
0.07
24
0.05
25
0.03
25
0.01
25
(0.01)
24
(0.03)
24
(0.05)
23
(0.06)

24

July 2001

Financial Derivatives

Option Trading Strategies

Directional Trade
Risk Reversal

15

Risk Reversal
- long 12m 110 call

12m to expiry
6m to expiry
3m to expiry
1m to expiry
expiry

10

- short 12m 90 put

Initially,
Gamma neutral
Theta neutral
Vega neutral

Risk Reversal price ($)

0
80

85

90

95

100

105

110

115

120

-5

Delta of 50 (a directional trade)

-10

Delta neutral if short 50

underlyings
* Gamma and vega flip from
positive to negative (i.e., risk
switches) across one point

S.K.Kang

-15
Underlying price ($)

Underlying
price
87
89
91
93
95
97
99
101
103
105
107
109
111

Profit and loss ($)

P&L
P&L
(+vol)
(+time)
(652)
(23)
0.47
(531)
(21)
0.43
(416)
(18)
0.37
(307)
(14)
0.29
(202)
(9)
0.19
(100)
(4)
0.08
0
2
(0.04)
102
7
(0.15)
205
13
(0.27)
311
18
(0.37)
422
22
(0.46)
538
26
(0.54)
660
29
(0.59)

P&L

Equivalent underlying position (units)

Equivalent
Gamma
underlying position
63
(0.20)
59
(0.18)
56
(0.14)
53
(0.11)
52
(0.07)
51
(0.03)
50
0.01
51
0.05
52
0.08
54
0.11
57
0.13
59
0.15
62
0.16

25

July 2001

Financial Derivatives

Section 3

Risk Reversal

S.K.Kang

26

July 2001

Financial Derivatives

Risk Reversal

Volatility Smile
The Black & Scholes model used to price options assumes that future spot
rates are lognormally distributed around the forward rate (A variable with a
lognormal distribution has the property that its natural logarithm is normally
distributed)
In reality, extreme outcomes are more likely than the lognormal distribution
suggests - The B&S model underestimates the probability of strong directional
spot movements and therefore undervalues options with low deltas
[2nd Adjustment]
Also, the B&S model does not
take into account any market
trends.
Accordingly, option traders
have to adjust their vol
prices such that strikes lying
in the trend will be more
expensive than the strikes
symmetrical to them
compared to the outright.

S.K.Kang

[1st Adjustment] Traders routinely compensate for these differences by

adjusting the at-the-money-forward vols for out-of-the-money strikes to more
accurately reflect the perceived risk
The manner in which traders adjust the at-the-money volatilities gives rise to
the characteristic smile of the vol curve - This is called the Smile Effect
For example, if the actual distribution shows fatter tails than that suggested
by the lognormal distribution (what is termed excess kurtosis), low delta
options will have been underpriced using B&S
Traders compensate for this by adding a spread above the ATMF vols to both
the low and high strike options

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Financial Derivatives

Risk Reversal

Volatility Smile
In theory, all strikes should
trade at the same vol since
they are all based on the
same underlying instrument.

If you graph implied volatility against the delta of an option, the profile will
look like a smile

The adjustments which traders

make to the ATMF vols in
order to quote high strike or
low strike options result in
the characteristic smile
profile.

Vol
High
Strike

Low
Strike

Smile Effect in a neutral

market:
The market has a neutral bias
towards higher or lower
strikes

ATMF

The price structure is

symmetrical
Only extreme strikes are
adjusted

50

100

Call Delta

100

50

Put Delta

* As a useful guide, remember that the volatility of a 20 delta call is the same as that of an 80 delta put
S.K.Kang

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Financial Derivatives

Risk Reversal

Volatility Smile
Smile Effect in a bullish market:
When high strike options are in
demand, the implied volatilities
need to be adjusted higher

Vol

The price structure is asymmetrical

High
Strike

The market favors higher strikes

(OTM Calls)

Low
Strike

Smile Effect in a bearish market:

When low strike options are in
demand, the implied volatilities
need to be adjusted higher

ATMF

The price structure is asymmetrical

The market favors lower strikes
(OTM Puts)
Since the curve may be shaped like a
lop-sided smile or a smirk or a
frown, people have been using the
term volatility skew instead of
volatility smile because the term
skew doesnt imply the sort of
symmetry that the term
smiledoes.
A smile curve can be defined for
every maturity. We may have a
rather neutral sentiment on the
short term but a bullish view on the
long term. Check the concept of
volatility surface (strike x
maturity x vol)
S.K.Kang

50

100

100

50

Call Delta
Put Delta

Vol
High
Strike

Low
Strike

ATMF

50

100

100

50

Call Delta
Put Delta
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Financial Derivatives

Risk Reversal

Risk Reversal - Definition & Quotation

* Instead of quoting exercise
prices directly, the convention
in the options market is to quote
prices for options with
particular deltas. Like the
practice of quoting implied
volatilities, the rationale for this
is to allow comparison of
quotes without needing to take
into account changes in the
underlying price. When referring
to the delta of options, market
participants also drop the sign
and the decimal point of the
delta. So for example, an OTM
put option with a B&S delta of

Now that it is clear how and why high strike and low strike vols differ from the
ATMF vols, it becomes important to understand how this is measured or obtained in
the market

-0.25 is referred to as a 25-delta

put.

As options with the same delta have the same sensitivity to the vol (or same vega),
risk reversals are vega neutral

A 25-delta risk reversal is

obtained by buying a 25-delta
option and selling a 25-delta
option in the opposite
direction

The risk reversal is the volatility spread between the level of vol quoted in the
market for a high strike option and the vol for a low strike option
Risk reversals are collars, where the bought option and the sold option have the
same delta

As a vega neutral structure, the vol spread will be more important than the actual
vol level
R/R are quoted as vol spreads
They will also have to reflect an eventual asymmetry of the Smile Effect

In this example, the OTM call is

more expensive than the
equally OTM put (compared
with what would be predicted
by the B&S model)

S.K.Kang

The market convention is to quote the difference between 25 delta strikes, however
any other delta may be priced
So, ignoring bid offer, if the vol of a 25 delta JPY put is 10.80%, and if the vol of a
25 delta JPY call is 11.20%, then the risk reversal would be quoted as 0.40, JPY
calls over, indicating that JPY calls are favored over JPY puts (a skewness towards
a large yen appreciation)
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Financial Derivatives

Risk Reversal

Risk Reversal - Definition & Quotation

R/R shows what direction the
market is favoring

Example

R/R also gives an indication of

the strength of the markets
expectations

USD/JPY 1 Month 25 Delta R/R

R/R indicates the degree of

skewness compared with the
lognormal distribution, which
itself is positively skewed

Vol 1M ATM: 9.5/9.8

0.1/0.3 USD Puts

Traders need to reach an

agreement on the actual level
of volatilities for the call and
put when trading R/R
To translate risk reversal
quotes into actual vols, one
requires information on
strangles or butterflies

S.K.Kang

Shows what the

trader favors
Bid:
Trader buys USD Put 9.6
& sells USD Call 9.5
i.e. he pays 0.1% vol away

Offer:
Trader sells USD Put 9.8
& buys USD Call 9.5
i.e. he receives 0.3% vol

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Financial Derivatives

Risk Reversal

Risk Reversals, Strangles and Butterflies

Standard option strategies are
usually constructed using 25 or
10 delta options
The three most commonly quoted
strategies are risk reversals,
strangles and butterflies
When the butterfly (or the strangle
quoted as a spread over ATMF
vol) is positive, this indicates
that the OTM options are more
expensive than the B&S model
would suggest. This is
indicative of a fat-tailed
distribution.

A 25 delta strangle is obtained by buying (or selling) a 25 delta call and a 25

delta put
Strangles are quoted in absolute volatility terms as the average of call and
put volatilities (often expressed as a spread over ATMF vol)
A long 25 delta butterfly is the combination of a short ATMF straddle and a
long 25 delta strangle
Butterflies are quoted as a spread between the strangles and the straddles
Observing both the risk reversal and the strangle (or the butterfly) allows the
calculation of two separate volatilities for the call and put
For example, from the following mid-market information,

In the example, Strangle = (Vol for

the call + Vol for the put) / 2 =
(11.1 + 10.1) / 2 = 10.6

ATMF vol = 10.0

Butterfly (or Strangle quoted as a spread over ATMF vol) = 0.6
R/R = 1.0 call over
Strangle = 10.0 + 0.6 = 10.6
Vol for the call = 10.6 + 1.0 / 2 = 11.1
Vol for the put = 10.6 1.0 / 2 = 10.1

S.K.Kang

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Financial Derivatives

Risk Reversal

Risk Reversal - Interpretation

One Impact of the R/R on
Pricing:

One can ask oneself whether a preference to hold or demand calls or puts (or
vice versa) gives any predictive capability on the direction of underlying

If high strikes are favored

over low strikes, the
additional expense of the
high strike versus the low
strike option is particularly
apparent when pricing zero
cost collars

The Fed has investigated whether the R/R has any predictive capability and
has found that the risk neutral moments implied by option prices and
extracted from them ... match actual realizations fairly well, but episodically
fail to predict the range of possible future exchange rates.

As the individual strikes of

the collars move away from
the forward level, the
differences between each
strike and the forward level
become more asymmetric
In other words, one has to
move the high strike level
farther away (from the
forward level) than the move
in the low strike in order to
maintain a net zero cost

The R/R can be sometimes a good indicator, as they reflect a punctual

consensus
However, the R/R is a better indicator of how the vol will move in the future
It does give a sense for where future vol levels are expected to be if the
underlying were to make a significant move one way or the other
Therefore, one has to be aware of the strikes corresponding to the 25 deltas of
the R/R
These 25 delta strikes may be at technical or psychological resistance or
support levels
Such a sensitivity to a particular level will be reflected in the vol skew made
by the options traders and thus the risk reversal market value
The R/R is a measure of the risk that options traders assign to these particular
strikes

S.K.Kang

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Financial Derivatives

Section 4

Summary

S.K.Kang

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Financial Derivatives

Summary

References
Buying and Selling Volatility - Kevin B. Connolly (Wiley, 1997)
Option Volatility & Pricing Sheldon Natenberg (Probus, 1994)
Foreign Exchange Options Alan Hicks (Woodhead, 1993)
Dynamic Hedging Nassim Taleb (Wiley, 1997)
Black-Scholes and Beyond Neil A. Chriss (Irwin, 1997)

S.K.Kang

35