Risk reversal - GetProfitable

A bullish risk reversal is short an out-of-the-money put and long an out-of-the-money call. Between the strikes almost nothing happens; outside them the position behaves like stock. It is synthetic-long-stock with a dead zone in the middle, and it costs little or nothing to establish.

In FX and commodities the phrase also means a quoted number: the implied volatility of the 25-delta call minus the 25-delta put, which is the market's standard measure of volatility-skew. Traders use the structure and the metric interchangeably, so check which sense is meant.

Example: XYZ at $50. Sell the 60-day $45 put at $0.95, buy the $55 call at $0.85, for a $0.10 credit. Above $55 you make money like a shareholder; below $45 you lose like one; between the two you have a free position and a large buying-power-reduction.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.

The volatility smile. Options on the same stock and the same expiry are not priced off one volatility. Strikes near the money carry the lowest implied volatility, and it rises towards both ends — usually faster on the downside, which tilts the smile into a skew.