Risk Reversal Price Break Charts Analysis for Currency Traders

The risk reversals (also known as the 25 Delta R/R) relating to a currency pair comprise a special set of data that is important to currency traders. The risk reversal is the implied volatility of the 25-delta call

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Figure 7.3 Six-Line Price Break Chart Reversal and Gold Option Trading

Source: Bloomberg

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Figure 7.3 Six-Line Price Break Chart Reversal and Gold Option Trading

Source: Bloomberg minus the implied volatility of the 25-delta put. Theoretically, if the market were neutral in sentiment on the direction, the implied volatilities would be the same. If the market favors one direction over the other, then the implied volatility of one 25-delta option (put or call) will be higher than that of the other. Often, the market skews in one direction. The degree of the skew is called a risk reversal. For the purposes of this book, risk reversals (RRs) are important because they often correlate with the direction of the underlying spot position. Essentially, RRs mirror market sentiment relating to the direction of the spot. We can see this in the chart of the AUDUSD currency pair overlaid with its risk reversals (Figure 7.4).

Serious forex option traders pay close attention to risk reversals as a directional indicator. There are two risk reversal strategies to employ. The first one is to go with the flow; if the smile is skewed one way, the direction of your next option trade should be, if this strategy is followed, in the direction of the skew. On the other hand, there may be times when the skew is very extreme, and at those moments, a strategy of trading in the reverse direction could be justified. In both cases, price break charts help. In the first scenario (trading in the direction of the skew), converting the RR line chart to a price break chart will indicate if the RR wave has in fact significantly reversed its direction. It is always better to ride the RR wave when it begins, as that is when there is strong trend sentiment. Price break charts help identify such a beginning. Playing a contrarian move would also be easier to implement with a price break chart, because the price break patterns would indicate whether the RR direction is becoming tired. If so, going against it may simply be anticipating an impending reversal.

Let's look again at the AUDUSD currency pair and its risk reversal chart. There is a close relationship between the RRs and the spot price movements. A trader who looks to the RR to decide in which direction to trade would have a high level of confidence that the RR chart is a powerful clue. Even greater confidence is achieved by converting the RR chart into its own price break chart. The resulting price break chart provides increased detail as to when there would be a change in direction and where it would occur. In Figure 7.5, which is the price break chart version of the RR chart in Figure 7.4, the reversal up on Dec 15 th signaled that the option sentiment had changed from a trend of consecutive lower RR levels, showing a favoring of put. The reversal

Figure 7.4 Line Chart of AUDUSD Risk Reversals

Source: Bloomberg

Figure 7.4 Line Chart of AUDUSD Risk Reversals

Source: Bloomberg

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Figure 7.5 Price Break Chart of AUDUSD Risk Reversals

Source: Bloomberg up, while still showing negative RR levels demonstrated a change in the tone of the sentiment. Using the price break chart reversal meant that going short on the AUDUSD was no longer supported by the risk reversal price break charts. Additionally, a trader following the RR logic and going long on the AUDUSD on Dec 15th, would have witnessed a sustained rise in the AUDUSD from approximately .70 on Dec 15th to .95 in March. On March 26th the AUDUSD25R1M price break chart reversed down for an exit signal. The price break signals provided the ability to ride the action to over 2000 pips.

We can look at the EURJPY currency pair as another example of how a price break view of the RR curve is helpful. First, we can see that there is a strong co-movement of the spot and the RR. The RR chart (Figure 7.6) shows a leveling off of the option sentiment that had favored the call side. Should the trader consider puts? The next step would be to see if the price break version of the RR (Figure 7.7) shows a reversal. It does! This would be a confirming signal to sell.

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