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A risk-reversal is an option position that consists of selling (that is, being short) an out of the money put and buying (i.e. being long) an out of the money call, both options expiring on the same expiration date. In this strategy, the investor will first form their market view on a stock or an index; if that view is bullish they will want to ...
These latter two are a short risk reversal position. So: Underlying − risk reversal = Collar. The premium income from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike price of the two options. Most commonly, the two strikes are roughly equal distances from the current price.
Risk reversals are generally quoted as x% delta risk reversal and essentially is Long x% delta call, and short x% delta put. Butterfly, on the other hand, is a strategy consisting of: −y% delta fly which mean Long y% delta call, Long y% delta put, short one ATM call and short one ATM put (small hat shape).
Risk reversal - simulates the motion of an underlying so sometimes these are referred as synthetic long or synthetic short positions depending on which position you are shorting. Collar - buy the underlying and then simultaneous buying of a put option below current price (floor) and selling a call option above the current price (cap).
It further neglects the cost of hedging the Vega risk. This has led to a more general formulation of the Vanna-Volga method in which one considers that within the Black–Scholes assumptions the exotic option's Vega, Vanna and Volga can be replicated by the weighted sum of three instruments:
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"Risk reversal" refers to the fact that, by entering such a trade, the investor is betting on a market recovery, where the underlying is rallying ("bullish" expectations). As opposed to a structure where the investor is risk adverse and would rather look for protection on the downside.
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