What it means
A risk reversal is an options structure combining a long out-of-the-money CALL and a short OTM PUT, both same expiration. Equivalent payoff to long the underlying at a synthetic forward price between the two strikes. Bullish bias: profits on upside, exposed to downside (limited by put strike). The premium received from the short put offsets the call premium — often resulting in zero-cost or low-cost structures. In FX trading, risk reversals are quoted directly (25-delta call minus 25-delta put IV) as a skew indicator.
Why it matters
Risk reversals are the canonical structure for bullish bets with reduced cost or directional exposures with capital efficiency. Institutional FX traders use risk reversals to express directional views with cleaner risk-reward than spot. The FX-quoted 25-delta risk reversal is a sentiment indicator — when call IV exceeds put IV (positive risk reversal), market expects more upside risk than downside.
How to use it
Use risk reversals to express directional views at lower cost than naked calls/puts. The short put provides funding but creates downside exposure — sizing must account for the put-strike-to-spot distance as the maximum loss zone. In FX, watch 25-delta risk reversal for sentiment shifts.
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