Risk Reversal

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Definition of 'Risk Reversal'

A risk reversal is a financial instrument that is used to trade the difference in implied volatilities of two options on the same underlying asset. It is a type of spread trade, and it is often used to hedge against or speculate on changes in volatility.

A risk reversal is created by buying a call option and selling a put option on the same underlying asset, with the same strike price and expiration date. The call option is purchased with a higher strike price than the put option, which means that the risk reversal is a bullish trade.

The payoff of a risk reversal is positive if the underlying asset price increases above the strike price of the call option, and it is negative if the underlying asset price decreases below the strike price of the put option. The maximum loss on a risk reversal is the difference between the strike prices of the two options, and the maximum gain is the premium received for selling the put option.

The risk reversal is a versatile instrument that can be used for a variety of purposes. It can be used to hedge against a decrease in volatility, or it can be used to speculate on an increase in volatility. It can also be used to create a synthetic long or short position on the underlying asset.

The risk reversal is a relatively complex instrument, and it is important to understand the risks involved before trading it. However, it can be a useful tool for managing risk or for speculating on volatility.

Here are some additional details about risk reversals:

* The risk reversal is a zero-sum game, which means that for every winner there is a loser.
* The risk reversal is a leveraged instrument, which means that it can magnify gains and losses.
* The risk reversal is a dynamic instrument, which means that its value changes over time as the underlying asset price and volatility change.

If you are considering trading risk reversals, it is important to consult with a financial advisor to make sure that you understand the risks involved.

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