# Risk reversals and volatility relationship

### 25 Delta Butterfly and Risk Reversal - Derivative Engines

An OTC volume index, market pin risk table and selected volatility and risk chart illustrates the historic relationship between one month delta risk reversals. can be derived from risk reversals (the volatility amount by which, for a given contemporaneous correlation rather than from lagged information that may. is the smile butterfly volatility. Then you have the volatility quote. See for example, FX Volatility Smile Construction by UWe Wystup (this link.

Volatility The two types of volatility we refer to on this site are historical and implied volatility. Historical volatility is measured from the actual movement of the stock over a time period. So the day historical volatility or hv20 is measured from how much the stock has actually moved in the previous day period. If the stock moves a lot the volatility will be higher than if the stock moves very little.

Implied volatility, on the other hand, is derived from the price of the option. The implied volatility is derived from the difference between the market price of an option and what the price would be given with just the inputs of stock price, strike price, time to expiration, interest rate, dividend, and cost to borrow stock.

The implied volatility tells you what the market predicts the volatility of the stock will be going forward. If the implied volatility is higher than historical volatility then the market is predicting that the stock will move about more going forward than it has in the past.

On a practical basis, when people buy options, market makers raise the price and when people sell them options, they lower it. Implied volatility is constantly changing. So if implied volatility is high on a particular option or a strike or a month, it usually means people have been buying those options.

Why do people buy particular options in large quantities? What do we mean by high?

**Implied Volatility and Options - Options for Volatility Course**

Generally, we mean higher than historical for the same period, but we may also mean in comparison to other option strikes or expirations or in comparison to implied vol in a previous period.

When implied volatility goes up the price of the option goes up because there is a greater chance that that option will finish in the money. So ideally you want to buy low volatility and sell high volatility. With directional trading, volatility may not be your primary consideration, but it should be considered as it should affect your choice of strategy. Volatility helps you assess the relative value of different options.

Some considerations in volatility: When looking at what options to buy or sell it is important to consider implied volatility. Take a look at implied volatility charts.

### Volatility – RiskReversal

If you are considering a front month option the month you are in then you should take a look at hv 20 or hv30 vs. If you are considering an option line two months out take a look at hv60 vs. If implied vol is trading considerably higher than historical then this is something to take into account. ACHN on January 18, Spike up on December 19th corresponds to a takeover of another company that also makes hepatitis C virus HCV drugs and rumors there might be other takeovers.

Also look at implied volatility over time. Is this the highest iv30 has traded all year? You always want to ask yourself why volatility may be up or down.

Has there been news about this product, are earnings coming up, is it a takeover candidate? How might a trader use this information?

- Risk reversal
- Volatility
- FX Options Risk Tool

Say we are feeling bullish and want to put on a call spread or butterfly but are wondering where. We might look at the day implied volatility of an underlying.

If you want to know what that predicts for one day or one month you need to do some square roots. Another common use of risk reversals is as a means to trading option skew.

## What is a risk reversal?

Suppose the trader think that the implied volatility of puts relative to calls is too high. He might consider selling puts to buy calls i. Now the trader is likely to delta hedge a combo when it is executed as a skew play.

This is because he is interested in the implied volatility levels of the options rather than their actual dollar values. Remember that delta hedging options effectively turns the strategy into a volatility play, rather than a directional play. In making a price in this combo, he will need to consider how accurate his model is in terms of implied volatility. Risk managing a risk reversal Risk reversals can be amongst the most challenging of all option strategies to price and manage.

Depending on the strikes of the put and the call in question, a risk reversal may have high or indeed low levels of vega, gamma, theta, vomma and vanna. To simplify this, the combo is often selected so that the put and call have similar levels of these Greeks and therefore many of them broadly cancel one another out. This is particularly common with respect to risk reversals when used as skew trades. Choosing a put and a call with similar values of the Greeks is one way to do this since obviously as the trader is selling one options and buying the other, much of the Greek risk will disappear.

A couple of caveats. Firstly, vanna is not minimised by trading a combo; it is pretty much maximised! Unlike say vega, which is positive for all options, vanna is positive for calls but negative for puts, so buying one option and selling the other has a doubling effect.