Nov 22 (Reuters) - Risk reversals are an FX option contract that plays on FX volatility, and a big shift in their premiums is very indicative for the EUR/USD outlook.
The FX volatility upon which FX options thrive is an unknown yet key part of their premium, so dealers use implied volatility as a stand-in. Any disparity between implied and actual/realised volatility can therefore be monetised.
Risk reversals charge an implied volatility premium for strikes in one direction versus a discount for strikes in the other. If the FX spot price moves in the direction of the premium strikes it should lift implied volatility and benefit those holding them.
The implied volatility premium for EUR puts over calls in EUR/USD risk reversals has surged this week, hitting its highest levels since early July amid strong demand. The benchmark 1-month 25-delta risk reversal climbed from 0.6 to 0.925, reflecting a notable premium for downside strikes compared to upside.
Implied volatility has indeed increased across all expiry dates. The benchmark 1-month expiry implied volatility is now 8.5 from 7.6 this week, having fallen from 9.0 to 6.25 in the immediate wake of the U.S. election.
These risk reversal gains have been accompanied by very strong demand and big size trading for outright USD calls, with 1.0200-1.0000 strikes proving very popular. These options will benefit from a weaker EUR/USD and implied volatility gains.
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(Richard Pace is a Reuters market analyst. The views expressed are his own)
((Richard.Pace@thomsonreuters.com))
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