Why are risk reversal (RR) and butterfly (BF) volatilities used in foreign exchange (FX) markets In layman's terms…

Why are risk reversal (RR) and butterfly (BF) volatilities used in foreign exchange (FX) markets In layman's terms…

 

Risk reversal (RR) and butterfly volatilities are used in foreign exchange (FX) markets to gain insights into market sentiment and potential price movements.

1. Risk Reversal (RR):

RR helps us understand the market's bias towards either bullish or bearish sentiment. It measures the difference in implied volatility between out-of-the-money (OTM) call options and OTM put options with the same expiration date.

 

25𝑅𝑅=25𝐷𝑒𝑙𝑡𝑎𝐶𝑎𝑙𝑉𝑜𝑙 −25𝐷𝑒𝑙𝑡𝑎𝑃𝑢𝑡𝑉𝑜𝑙

 

The 25 delta options are considered close to the ATM level. They have approximately a 25% chance of expiring in-the-money or out-of-the-money. By choosing options around this level, market participants aim to capture the market's expectation of future price movements without the skew introduced by deep in-the-money or out-of-the-money options.

Options with a 25 delta strike price often exhibit higher liquidity and trading volume compared to options at other strike prices.

In FX markets, RR is particularly useful because it reveals whether market participants are more concerned about potential upside or downside movements in a currency pair. A positive RR indicates a higher implied volatility for call options, suggesting a relatively stronger bullish sentiment. Conversely, a negative RR suggests a higher implied volatility for put options, reflecting a relatively stronger bearish sentiment.

By analyzing RR in FX markets, traders and investors can gauge market expectations and sentiment regarding the future direction of a currency pair. It can provide insights into potential shifts in supply and demand.

2. Butterfly (BF) Volatility:

Butterfly volatility represents the implied volatility of at-the-money (ATM) options with the same expiration date. It helps us understand the market's expectation of price stability or potential upcoming events that could lead to significant price movements.

 

25 𝐵𝐹 = 25 𝐷𝑒𝑙𝑡𝑎 𝐶𝑎𝑙 𝑉𝑜𝑙 + 25 𝐷𝑒𝑙𝑡𝑎 𝑃𝑢𝑡 𝑉𝑜𝑙 − 𝐴𝑇𝑀

 

In FX markets, butterfly volatility is useful for identifying periods of heightened uncertainty or potential volatility. Higher butterfly volatility suggests increased market expectations of significant price movements in the near term.

In the context of options trading, particularly in FX markets, the implied volatility skew is commonly observed. It indicates that the implied volatility of options with different strike prices deviates from the at-the-money (ATM) level. This skew is typically seen as a result of market expectations and sentiment.

In summary, implied volatility skew, risk reversal, and butterfly volatility are interconnected concepts that provide insights into different aspects of market sentiment and expectations.

 

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