How to use risk reversals to analyse forex market sentiment

How to use risk reversals to analyse forex market sentiment

Reading time: 12 minutes

On most trading forums and chat rooms, you will see traders and investors implement a range of methods to assess market sentiment. At one end of the spectrum, price action traders evaluate trends and breakouts to decipher who is in the driving seat; others use positioning data from the Commodity Futures Trading Commission (CFTC) and news.

While I also use these methods regularly, I feel risk reversals offer a different kind of edge for FX sentiment, showing what market participants are willing to pay to protect against or profit from.

What are risk reversals?

In FX trading, risk reversals help gauge how traders are feeling through the options market.

Risk reversals show the difference in implied volatility (the amount of future price movement baked into an option's price) between out-of-the-money (OTM) calls and puts that sit the same ‘distance’ from the current exchange rate (what traders call ‘delta’). They are usually quoted as call volatility minus put volatility, so a positive reading means calls are in greater demand and a negative reading means puts are.

This helps assess whether traders are more bullish or bearish on the base currency, which is why they are great for gauging sentiment in the FX space.

I understand that is a mouthful, but bear with me as I will take you through it step by step.

Puts and calls?

For a currency pair, a call option bets the ‘base’ currency will rise versus the second currency – the ‘quote’ or ‘term’ currency. A put option, on the other hand, bets it will fall. Take EUR/USD, for example; a call (put) bets the pair rises (falls).

Every FX option is simultaneously a call on one currency and a put on the other. Entering a long EUR call also means buying a USD put; you secure the right to buy euros by selling dollars. A bearish view on EUR/USD means buying a EUR put and buying a USD call. You are buying the right to sell euros by buying dollars. The same applies to any currency pair in the options market.

What does OTM mean?

In the options market, you must understand three key terms: OTM, ATM (at-the-money), and ITM (in-the-money). These all relate to the ‘strike price’ – that is, the fixed price level you select when entering the market, be that a call (the right to buy) or a put (the right to sell). This is the price at which you can buy (sell) the underlying currency if the options contract is exercised. Do not confuse this with closing the trade; it is not. Exercising an options contract essentially means that you have triggered your right to buy or sell the underlying asset, which in this case is a currency.

The strike price matters a great deal to option traders, as it determines the option's price (premium) and, largely, its risk. The currency pair trades at the current market price (spot price), and how the strike price compares with the spot price determines whether the option is OTM, ATM or ITM.

OTM

If your options contract is OTM at expiry, it would be pointless to exercise your contractual right, as it is not yet profitable.

For a call option, this means the spot price is below the strike price. EUR/USD trading at US$1.1200, with a strike price of US$1.1250, shows this is an OTM options contract. Until the spot price rises above US$1.1250, the option has no ‘intrinsic value’, meaning it would be worth nothing if it expired today. It still has a ‘premium’, because there is time left for the market to move in your favour, but that is it.

ATM

ATM is probably the simplest to remember, as it means the spot price equals – or is very close to – the strike price. Sticking with the same example as above, EUR/USD trading at US$1.1200 and the options strike price of US$1.1201 would be considered ATM, whether it is a call or a put.

ITM

As I am sure you have guessed by now, ITM means the spot price is above (below) the strike price for a call (put). Ultimately, you want an options contract that eventually trades ITM, as it is profitable, assuming you factor in the premium you paid (remember: as an options buyer, you pay premium; as a seller, you collect it).

For a call, the spot price is above the strike price; for a put, it is below. If EUR/USD trades at US$1.1400 and the strike price is US$1.1250, you can buy EUR/USD at US$1.1250 when spot is trading at US$1.1400.

What does delta mean?

Delta is a market-implied ‘gauge’ of whether the option contract will finish ITM, but it is not an exact approximation; it is more of a rough guide. Delta also measures how much an option’s price moves when the underlying currency pair does.

Based on a scale between 0 and 1 (or 0 and 100 in percentage terms), a delta of 50 – which is an option trading ‘ATM’ – means there is a 50% chance the trade ends up ITM. Importantly, when buying options, you will have to factor in the premium already paid; therefore, the chance of ending in the green is actually less than the probability of finishing ITM.

Risk reversals tend to focus on 25-delta options – which are OTM. This means there is a 25% chance the trade ends ITM and a 75% chance it ends OTM. Because a 25-delta EUR call and a 25-delta EUR put sit the same statistical distance from the current exchange rate, they should theoretically have the same implied volatility if the market is perfectly neutral. Premiums can still differ slightly.

If you buy a 25-delta EUR call and EUR/USD rises by 100 pips (or 1 cent), the option’s value rises by roughly 25 pips (or a quarter of a cent). Deep ITM options have deltas near 1 because they move almost one-for-one with the market. Far OTM options have deltas near 0.

Why traders use delta instead of strike. A strike 100 pips away is far out for a one-week option but close for a one-year option. Delta adjusts for time to expiry and volatility, so a 25 delta option always represents roughly the same degree of what is referred to as ‘out-of-the-moneyness’. That makes it a consistent yardstick for traders to use.

How can I use risk reversals to gauge FX market sentiment?

When risk reversals rise, calls become more expensive relative to puts, pointing to stronger demand for upside exposure in the base currency. When they fall, puts are in greater demand, suggesting stronger demand for downside exposure.

That demand can come from two sources. Rising risk reversals may reflect traders who are long the pair and positioning for further gains, or traders who are short and buying calls to protect against a rally. The same applies in reverse: falling risk reversals may reflect traders bracing for a decline, or long holders buying puts as downside protection. Because the reading blends speculation and hedging, treat it as a gauge of sentiment and positioning, not a forecast.

So, what does this mean for your trading? If you see risk reversals rising (falling), it indicates a more bullish (bearish) bias. This is especially true in a trend, as it opens the door to dip-buying and rally-selling opportunities.

Another way to use risk reversals is to look for when they become unusually high or low, signalling potential overbought or oversold conditions from an options perspective. You are looking for mispricings here (stretched sentiment). A reading is unusual when it sits far from its own average, which you can measure with a z-score (how many standard deviations the reading is from its average).

One other way I use risk reversals is to look for divergences between the spot price and the risk reversals. What I mean is that if risk reversals are rising (falling) but the spot price of a currency pair is steady or falling (rising), this can indicate a possible push higher (lower) in the spot price.

Conclusion

Risk reversals compress a great deal of information into a single number: the difference in implied volatility between equally distant calls and puts. A positive reading means the market is paying more for upside in the base currency; a negative reading means it is paying more for downside protection. Because that pricing reflects real demand for protection and speculation, it offers a view of sentiment that price charts alone cannot.

Professional terminals such as Bloomberg and LSEG provide risk reversal quotes across tenors and deltas for most major and many minor pairs. Some research providers publish daily or weekly options-market summaries, and a few offer charts of one-month and three-month risk reversals for the major pairs.

If you do not have terminal access, look for research pages, central bank or market-structure reports that reference option skew, and data vendors that offer delayed volatility surface data.

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Written by FP Markets Chief Market Analyst, Aaron Hill