Risk reversals are a widely used strategy in FX options to take advantage of volatility, and they also provide important insights into market sentiment and directional trends. Recently, EUR/USD risk reversals have experienced a notable transition from favouring higher strike prices to leaning towards lower strike prices.
Volatility, a significant and unpredictable factor in FX option premiums, is indicated by implied volatility. Fluctuations in implied volatility reflect traders’ expectations regarding future risks associated with the underlying asset. Risk reversals require an implied volatility premium for options with strikes likely to experience an increase in volatility in the currency market.
The benchmark 1-month EUR/USD 25 delta risk reversal has rapidly shifted from 0.7 USD puts (higher strike prices) last week to 0.45 USD calls (lower strike prices) on Thursday. This reversal has negated the gains that reached 5-year highs of 1.35 for higher strike prices following the U.S. tariff announcement on April 2 and the subsequent decline of the USD. Other expiration dates have also experienced a decline in their higher strike premiums, although the longer-term losses (for 6-12 month expirations) are more moderate.
The onset of this price movement preceded the decrease in the EUR/USD spot rates from levels above 1.1600 last week, but it appears excessive based on historical context.
Traders point to various factors:
1. The USD has regained some of its previous position as a safe haven due to the Iran/Israel conflict, with any escalation and rising oil prices likely benefitting the USD over currencies like the EUR, which relies on oil imports.
2. Topside fatigue: The heavy positioning of both spot and options markets in favour of EUR/USD made the market vulnerable to a short squeeze or correction.
3. FX hedging – long positions in EUR/USD are at risk, leading investors to realise profits by reducing their positions and overwhelming the options market with higher strike options. Additionally, there has been increased demand for lower strike hedges to protect against potential further declines in EUR/USD.
Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.
Past performance is not indicative of future results.
High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% and 75% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Futures and Options: Trading futures and options on margin carries a high degree of risk and may result in losses exceeding your initial investment. These products are not suitable for all investors. Ensure you fully understand the risks and take appropriate care to manage your risk.
Patrick has been involved in the financial markets for well over a decade as a self-educated professional trader and money manager. Flitting between the roles of market commentator, analyst and mentor, Patrick has improved the technical skills and psychological stance of literally hundreds of traders – coaching them to become savvy market operators!