Risk Reversals and Skew Trading

A risk reversal funds a cheap call by selling a put, carrying the same downside risk while also serving as the market's skew gauge.

A risk reversal buys an out of the money call and sells an out of the money put, or the reverse, and it serves two purposes at once: a cheap or even credit financed way to express a directional view, and the standard instrument traders use to measure and trade skew, the difference in implied volatility between downside puts and upside calls at the same distance from the current price.

With a stock at $102 and 30 days to expiry, buy a $110 call at $0.85 and sell a $95 put at $1.45. The put brings in more premium than the call costs because equity skew usually prices downside puts richer than equidistant upside calls, reflecting steady demand for downside protection, so the combination is put on for a net credit of $1.45 minus $0.85, or $0.60.

At expiry, if the stock finishes at $115, the call is worth $5 against its $0.85 cost, a gain of $4.15 on that leg, while the put expires worthless and the full $1.45 premium is kept, for a combined profit of $5.60. If the stock instead falls to $90, the put is assigned and the trader must buy stock at $95 that is worth $90, a loss of $5 on that leg net of the $1.45 already collected, or negative $3.55, while the call expires worthless for a further $0.85 loss, a combined loss of $4.40.

The downside scenario is the important one to internalize. A risk reversal built this way carries the same obligation as a short put: an outright loss if the stock falls meaningfully, only partially offset by the small credit collected and the cheap call. It funds a bullish call by accepting exactly the downside a short put carries on its own, which is a different risk profile from simply owning a call outright.

The same structure, quoted as the volatility difference between the put and the call rather than as a dollar price, is the market's standard measure of skew. A 25 delta risk reversal quoted at a negative number means the 25 delta put trades at a higher implied volatility than the 25 delta call, and the more negative that number, the steeper the market is pricing downside risk relative to upside potential, a relationship covered in more detail in the volatility smile and skew piece.