Options market risk reversals have long been known as a gauge of financial market sentiment, and this article highlights two key strategies in using FX options risk reversals to trade major currency pairs. Using automated trading software we can view the hypothetical performance of such systems and make forward-looking forecasts on major currency pairs. FX Options Risk Reversals: What are they and how can we use them? In our last Forex Strategy Corner article , we discussed the importance of volatility expectations in pricing FX options and how to use them in gauging market conditions.
FX options risk reversals take volatility analysis one step further and use them not to predict market conditions but as a gauge of sentiment on a specific currency pair.
Thus if we compare implied volatility levels across a series of options, we can get a sense for trader sentiment on a direction for a specific currency pair. Volatility smiles most frequently show that traders are willing to pay higher implied volatility prices as the strike price grows aggressively out of the money. We are subsequently interested in the relative shape of the curve; the chart above shows that options traders are paying a significant volatility premium for OTM EURUSD puts versus the equivalent calls.
We can compare equivalently OTM puts and call with a single number: Yet we have found it is a bit more difficult to use the absolute Risk Reversal number in creating set strategies, as different dynamics across currency pairs complicates standardization of strategy rules.
As such, we distill the risk reversal number into a rolling day percentile. Why 90 trading days? A study of the EURUSD finds that such a time period was particularly successful in picking noteworthy tops and bottoms for much of and Thus we will work this concept into two distinct strategies that have historically had a fair deal of success across different currency pairs.
Using such software we can determine the historical profitability and theoretical viability of both of our proposed strategies.
When the Risk Reversal hits its bottom 5 th percentile in the past 90 days, buy. If it hits its top 5 th percentile, sell. Close the long position if the Risk Reversal hits its 45 th percentile or above. Cover the short position if the Risk Reversal hits its 55 th percentile or below. Through the pictured time frame, risk reversal extremes in either direction provided accurate signals for reversal and great timing tools.
Yet a major caveat with these results is that the same principles do not work across all currency pairs. One can speculate as to why this may be the case, but it seems relatively clear that we would have needed a different approach to catch major swings in this often-volatile currency pair.
Thus we are left to discuss our second trading strategy: When the Risk Reversal hits its bottom 5 th percentile or below as it relates to previous 90 days, go short. If it hits its top 5 th percentile or above, go long. Close the long position if the Risk Reversal hits its 70 th percentile or below.
Cover the short position if the risk reversal hits its 30 th percentile or above. Given that the British Pound performed especially poorly with the Range Trading system, it should be relatively little surprise to see that it is an outperformer with the dissimilar Breakout-style trading strategy. And though past performance is never a guarantee of future results, such consistent gains suggest that there is more to such gains than pure coincidence.
The sudden downturn in performance in the AUDUSD equity curve emphasizes that nothing ever works all of the time, and certainly these strategies were developed with the benefit of hindsight. Yet the relatively intuitive rules behind the strategies should hold some truth. Attempting to quantify exact trading parameters is consistently difficult, and developing something that works well as a completely automated system is far from a straightforward task.
Risk reversals nonetheless show some promise using different trading styles on the major currency pairs, and this suggests that we can use it as another confirming indicator in timing medium-to-longer term swing trades. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
Click here to dismiss. Big data analysis, algorithmic trading, and retail trader sentiment. Down Trend Starting to Resume? Using Candlestick Formations in Trading. Upcoming Events Economic Event. Forex Economic Calendar A:More...