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.

Given that implied volatility is one of the most important determinants of an option’s price, we use it as a proxy for market demand for a specific option. 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.

Risk Reversals compare the volatility paid/charged on out of the money calls versus out of the money puts. An aggressively out of the money (OTM) option is often seen as a speculative bet/hedge that the currency will move sharply in the direction of the strike price. The “Volatility Smile” chart below plots volatility—our proxy for demand—for OTM calls and puts.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_5.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

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: the risk reversal.

Risk Reversal = Implied Volatility on OTM Call – Implied Volatility on OTM Put

Using Risk Reversals to Predict Price

In our FX Options Weekly Forecast, we use Risk Reversals to gauge trends and shifts in trends for major currency pairs. 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 90-day percentile. This tells us how bullish or bearish FX Options traders’ sentiment is in relation to the preceding 90 trading days. 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 2009 and 2010.

The chart below shows that the EURUSD set several important tops and bottoms when the 90-day FX Options risk reversal hit 100 and 0 percent, respectively.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_6.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

Thus we will work this concept into two distinct strategies that have historically had a fair deal of success across different currency pairs. Using algorithmic trading software, we will download FX Options Risk Reversals data into common text-based spreadsheet files and import them into FXCM’s Strategy Trader software. Using such software we can determine the historical profitability and theoretical viability of both of our proposed strategies.

Forex Options Risk Reversals Range Trading Strategy

Entry Rule: When the Risk Reversal hits its bottom 5th percentile in the past 90 days, buy. If it hits its top 5th percentile, sell.

Stop Loss: None by default

Take Profit: None by default

Exit Rule: Close the long position if the Risk Reversal hits its 45th percentile or above. Cover the short position if the Risk Reversal hits its 55th percentile or below.

Results for Forex Options Risk Reversals Range Trading Strategy

As the EURUSD chart suggests above, this strategy has historically performed quite well in the EURUSD. Through the pictured time frame, risk reversal extremes in either direction provided accurate signals for reversal and great timing tools.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_7.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

Yet a major caveat with these results is that the same principles do not work across all currency pairs. This range trading strategy has performed relatively well in the EURUSD, USDJPY, and USDCHF pairs over the past several years of hypothetical results. Yet the same strategy used on the British Pound/US Dollar pair has seen consistent and large losses.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_8.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

The hypothetical equity curve above emphasizes that the same strategy would have done very poorly trading the GBP/USD pair. 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. Its tendency to enter prolonged trends is perhaps one of the reasons why it is not suited to this “Range Trading”-style system. Thus we are left to discuss our second trading strategy:

Forex Options Risk Reversals Breakout Trading Strategy

Entry Rule: When the Risk Reversal hits its bottom 5th percentile or below as it relates to previous 90 days, go short. If it hits its top 5th percentile or above, go long.

Stop Loss: None by default

Take Profit: None by default

Exit Rule: Close the long position if the Risk Reversal hits its 70th percentile or below. Cover the short position if the risk reversal hits its 30th percentile or above.

Results for Forex Options Risk Reversals Breakout Trading Strategy

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.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_9.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

The above trading curve quite honestly looks too good to be true, as the strategy has hypothetically enjoyed truly impressive performance trading on the GBP/USD pair. 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 strategy has enjoyed similar stretches of outperformance with the Australian Dollar/US Dollar currency pair, but no equity curves look quite as good as the GBPUSD.

Forex_Strategy_Corner_FX_Options_Risk_Reversals_Trading_Strategy_body_Picture_10.png, Forex Strategy Corner: FX Options Risk Reversals Trading Strategy

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.

Further Resources

View updates on FX Options Risk Reversals and these two trading styles every Wednesday on DailyFX.com’s Technical Section. Past and future reports will appear under “Forex Options Weekly Forecast”.

View previous articles in this series:

Click on the tab below that reads “Previous Articles from Forex Strategy Corner”.

Written by David Rodríguez, Quantitative Strategist for DailyFX.com

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