Forex Strategy Corner: FX Options Risk Reversals Trading Strategy.
Big data analysis, algorithmic trading, and retail trader sentiment.
Options market risk reversals have long been known as a gauge of financial market sentiment, and this article highlights two key strategies in using FX options risk reversals to trade major currency pairs. Using automated trading software we can view the hypothetical performance of such systems and make forward-looking forecasts on major currency pairs.
FX Options Risk Reversals: What are they and how can we use them?
In our last Forex Strategy Corner article , we discussed the importance of volatility expectations in pricing FX options and how to use them in gauging market conditions. FX options risk reversals take volatility analysis one step further and use them not to predict market conditions but as a gauge of sentiment on a specific currency pair.
Given that implied volatility is one of the most important determinants of an option’s price, we use it as a proxy for market demand for a specific option. Thus if we compare implied volatility levels across a series of options, we can get a sense for trader sentiment on a direction for a specific currency pair.
Risk Reversals compare the volatility paid/charged on out of the money calls versus out of the money puts. An aggressively out of the money (OTM) option is often seen as a speculative bet/hedge that the currency will move sharply in the direction of the strike price. The “Volatility Smile” chart below plots volatility—our proxy for demand—for OTM calls and puts.
Volatility smiles most frequently show that traders are willing to pay higher implied volatility prices as the strike price grows aggressively out of the money. We are subsequently interested in the relative shape of the curve; the chart above shows that options traders are paying a significant volatility premium for OTM EURUSD puts versus the equivalent calls. We can compare equivalently OTM puts and call with a single number: the risk reversal.
Risk Reversal = Implied Volatility on OTM Call – Implied Volatility on OTM Put.
Using Risk Reversals to Predict Price.
In our FX Options Weekly Forecast, we use Risk Reversals to gauge trends and shifts in trends for major currency pairs. Yet we have found it is a bit more difficult to use the absolute Risk Reversal number in creating set strategies, as different dynamics across currency pairs complicates standardization of strategy rules.
As such, we distill the risk reversal number into a rolling 90-day percentile. This tells us how bullish or bearish FX Options traders’ sentiment is in relation to the preceding 90 trading days. Why 90 trading days? A study of the EURUSD finds that such a time period was particularly successful in picking noteworthy tops and bottoms for much of 2009 and 2010.
The chart below shows that the EURUSD set several important tops and bottoms when the 90-day FX Options risk reversal hit 100 and 0 percent, respectively.
Thus we will work this concept into two distinct strategies that have historically had a fair deal of success across different currency pairs. Using algorithmic trading software, we will download FX Options Risk Reversals data into common text-based spreadsheet files and import them into FXCM’s Strategy Trader software. Using such software we can determine the historical profitability and theoretical viability of both of our proposed strategies.
Forex Options Risk Reversals Range Trading Strategy.
Entry Rule: When the Risk Reversal hits its bottom 5 th percentile in the past 90 days, buy. If it hits its top 5 th percentile, sell.
Stop Loss: None by default.
Take Profit : None by default.
Exit Rule: Close the long position if the Risk Reversal hits its 45 th percentile or above. Cover the short position if the Risk Reversal hits its 55 th percentile or below.
Results for Forex Options Risk Reversals Range Trading Strategy.
As the EURUSD chart suggests above, this strategy has historically performed quite well in the EURUSD. Through the pictured time frame, risk reversal extremes in either direction provided accurate signals for reversal and great timing tools.
Yet a major caveat with these results is that the same principles do not work across all currency pairs. This range trading strategy has performed relatively well in the EURUSD, USDJPY, and USDCHF pairs over the past several years of hypothetical results. Yet the same strategy used on the British Pound/US Dollar pair has seen consistent and large losses.
The hypothetical equity curve above emphasizes that the same strategy would have done very poorly trading the GBP/USD pair. One can speculate as to why this may be the case, but it seems relatively clear that we would have needed a different approach to catch major swings in this often-volatile currency pair. Its tendency to enter prolonged trends is perhaps one of the reasons why it is not suited to this “Range Trading”-style system. Thus we are left to discuss our second trading strategy:
Forex Options Risk Reversals Breakout Trading Strategy.
Entry Rule: When the Risk Reversal hits its bottom 5 th percentile or below as it relates to previous 90 days, go short. If it hits its top 5 th percentile or above, go long.
Stop Loss: None by default.
Take Profit : None by default.
Exit Rule: Close the long position if the Risk Reversal hits its 70 th percentile or below. Cover the short position if the risk reversal hits its 30 th percentile or above.
Results for Forex Options Risk Reversals Breakout Trading Strategy.
Given that the British Pound performed especially poorly with the Range Trading system, it should be relatively little surprise to see that it is an outperformer with the dissimilar Breakout-style trading strategy.
The above trading curve quite honestly looks too good to be true, as the strategy has hypothetically enjoyed truly impressive performance trading on the GBP/USD pair. And though past performance is never a guarantee of future results, such consistent gains suggest that there is more to such gains than pure coincidence.
The strategy has enjoyed similar stretches of outperformance with the Australian Dollar/US Dollar currency pair, but no equity curves look quite as good as the GBPUSD.
The sudden downturn in performance in the AUDUSD equity curve emphasizes that nothing ever works all of the time, and certainly these strategies were developed with the benefit of hindsight. Yet the relatively intuitive rules behind the strategies should hold some truth. Attempting to quantify exact trading parameters is consistently difficult, and developing something that works well as a completely automated system is far from a straightforward task.
Risk reversals nonetheless show some promise using different trading styles on the major currency pairs, and this suggests that we can use it as another confirming indicator in timing medium-to-longer term swing trades.
View updates on FX Options Risk Reversals and these two trading styles every Wednesday on DailyFX’s Technical Section . Past and future reports will appear under “Forex Options Weekly Forecast”.
View previous articles in this series:
Click on the tab below that reads “Previous Articles from Forex Strategy Corner” .
Written by David Rodríguez, Quantitative Strategist for DailyFX.
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RRFXSTRATEGY.
RR - FX STRATEGY - Trading Economics - EUR/USD.
Because the forex market place is all about the value of one currency relative to another currency, all forex trading takes place in currency pairs. Today, seven currency pairs represent about 85% of all forex trades:
If you study this list for a moment, two things will become clear. One is that the countries shown here represent some of the world? s largest economies. The other is that US dollar is a part of every one of the SEVEN MAJOR PAIRS [G7], making it the most traded currency worldwide.
The reason these seven pairs are the MAJORS is simple; the economic power.
Together, these seven countries generated 68%, or two-thirds, of the world economic activity! Currency value and economic strength are intimately related.
The global forex market is massive. Daily trading volume is currently equal to about $4 trillion ? and again, that is Daily Volume. By comparison, the US gross domestic product (GDP) for the year 2010 was $14.5 trillion. And as per McKinsey Global Institute report ? at the end of 2010, global equity (stock) market capitalization and outstanding bonds and loans represented $212 trillion. In other words, the world? s total financial value changes hands on the forex market every 50 days!
Regardless of the source in FX trading ? the greatest benefit of this massive trading volume can be summed up in one word: LIQUIDITY. If you own land or a house, you can sell it, but doing so will probably take weeks or months. If you own a Picasso or Renoir painting worth millions, you can sell it too, but doing so could even take years. Neither real estate nor collectible art is considered liquid asset in that they cannot readily be exchanged for cash.
The tremendous amount of currency changing hands every day means there are plenty of buyers and sellers in the market. This is a part of what makes trading exotic pairs riskier ? liquidity is much lower for low-demand currencies than for the majors, in the same way that IBM and Apple stocks are more attractive than penny stocks.
It has really been the advent of the Internet that has permitted individuals to participate in the forex markets.
As I mentioned that forex trading is in many ways simpler than equity trading, since there are fewer currency pairs [7 Major] than there are stocks [1,000s]. It is also important to understand that currency prices move differently. While a stock can climb or fall within a huge range [10%] ? currencies, by comparison, tend to move within a relatively narrow range [1%]. This is because each currency represents economic condition of the home country, which will only vary so much in a short period of time within the global economy. And because central banks intervene to affect valuation in the event their currency becomes too strong or too weak.
There are certain fundamentals that affect currency value and fundamental analysis is geared more for long term trading. Technical analysis tends to be more appropriate for short term trading. Much of the forex trading by speculators is based on technical analysis.
There are two basic approaches to formulating forex trading strategies:
Fundamental analysis looks at these issues to making trading decisions:
In this way, it is similar to analyzing the financial statement of a company when deciding whether to buy its stock.
Because of the nature of the underlying mechanics, fundamental analysis is geared more for Long Term trading. Technical analysis tends to be more appropriate for short-term trading. However, it is possible to combine aspects of both. For example, fundamentals might indicate the future course a currency is likely to move. The technical indicators can provide the signals to show when that movement is beginning.
Fundamental analysis looks at these issues to making trading decisions:
Yield advantage is not the only factor. You need rising yield [differential] in the target currency too. It means: Growth + Yield = Gains.
Mostly FX Gain is driven by three factors:
Ø Central Banks policy differentials.
One important factor that distinguishes forex from equities is the role of Central Banks. While companies take actions [increase revenue, cut cost, issue dividend] to effect the price of their stock, in most cases they have little power to affect it substantially; the market makes those decisions. A currency, however, is not something to be traded in the market place; it is the economic lifeblood of a country. Valuations that are too strong or weak have real important impacts on the economy, so each central bank is charged with governing its currency.
Central banks manage/intervene the relative strength of their currency against others because overly strong and weak currencies have negative economic effects. A strong currency makes a nation? s export more expensive. A weak currency may increase the price of imported goods and thus inflation.
Because of the nature of the underlying mechanics, fundamental analysis is geared more for Long Term trading. Technical analysis tends to be more appropriate for short-term trading. However, it is possible to combine aspects of both. For example, fundamentals might indicate the future course a currency is likely to move. The technical indicators can provide the signals to show when that movement is beginning.
A technical rally is one thing, but validation by fundamental makes for a strong trend. When strong fundamentals support and validate a technical trend, the result is generally a continuation of the trend. When it comes to currencies, trends can last a very long time.

Risk Reversal.
What is a 'Risk Reversal'
A risk reversal, in commodities trading, is a hedge strategy that consists of selling a call and buying a put option. This strategy protects against unfavorable, downward price movements but limits the profits that can be made from favorable upward price movements. In foreign exchange (FX) trading, risk reversal is the difference in volatility, or delta, between similar call and put options, which conveys market information used to make trading decisions.
BREAKING DOWN 'Risk Reversal'
Risk Reversal Mechanics.
If an investor is short an underlying instrument, the investor hedges the position implementing a long risk reversal by purchasing a call option and writing a put option on the underlying instrument. Conversely, if an investor is long an underlying instrument, the investor shorts a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying instrument.
Commodities Risk Reversal Example.
For example, say Producer ABC purchased an $11 June put option and sold a $13.50 June call option at even money; the put and call premiums are equal. Under this scenario, the producer is protected against any price moves in June below $11 but the benefit of upward price movements reaches the maximum limit at $13.50.
Foreign Exchange Options Risk Reversal Example.
Risk reversal refers to the manner in which similar out-of-the-money call and put options, usually FX options, are quoted by dealers. Instead of quoting these options' prices, dealers quote their volatility. The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the FX market and convey information to make trading decisions.

Rr forex strategy

Time Frame(TF): In any TIME FRAME it works, but it better works in 1H, 4H and Daily. Success ratio is not counted in lower TF(less than 1H).
Indicator: MACD and Price Action(only in 4H or higher TIME FRAME).
Currency Pairs: It works in any pair provided by your brokers.
My maximum trading system is based on divergence. All of us are acquainted with divergence. Divergence is better understood when it is history, but it is not so easy to use in real time trading as it can finish apparently seemed divergence into a convergence. An example of failed divergence.
There are several filtering I use in my divergence related trading systems, but here I am describing one way to filter it and it is a complete but very easy trading system.
My filtering is named as Divergence-Breakout .
I shall not go for linguistic analysis but I shall try to give images which will be self explanatory.
For the people who are unaware of divergence I am narrating in brief about it. Normally when price of currency goes up an indicator makes higher high, and when price of currency is downward in normal sense indicator makes lower low. If the picture is different than we say a divergence is made. I have explained it in the following image.
Guys I am not giving analysis on divergence. But who are not known about divergence can be benefitted from this image. For a details analysis anyone can search in google to know about Regular and Hidden Divergence.
#· #Success rate: In 1H TF success rate is 70%
· #Reward Risk Ratio: 1.5:1 or more.
· #Consecutive Loss: It can consecutively give you 6-8 losses.
· #Consecutive Wins: It can consecutively give you 6-8 profits also.
Explanation of Divergence-Breakout System in images:
We don’t take trades if divergence happens. We take after the break out. What kind of break out me use?
Here is an image of break out:
I have tried my best to explain all the necessary things with sequential numbers of 1,2,3,4,5,6,7,8…. Please follow those numbers to understand my ideas about DIVERGENCE-BREAKOUT.
Just see the above image. EU is going from 1.35 levels to near about 1.50 levels not giving any kind of DIVERGENCE - BREAK OUT in daily. This was a pure long trend. So fractal LONG trading in lower time frame was more profitable than short in this zone. What this DIVERGENCE-BREAKTOUT shows us? Actually I first of all find out the TREND from this DIVERGENCE-BREAKOUT in higher TF, and then in fractal trading I use the same DIVERGENCE-BREAKOUT in lower TF like 1H or 4H or sometimes even in 15min.
Here is an example:
If I find DAILY DIVERGENCE-BREAKOUT for LONG trade then I trade in 4H or 1H with the same DIVERGENCE-BREAKOUT system for LONG trades. I don’t go for short in that zone.
Or suppose I have got a DIVERGENCE-BREAKOUT for LONG in 4H then I trade in 1H and 15 min only LONG trades with this DIVERGENCE BREAKOUT.
I guess you have got my ideas. You just check it and I guess you will be amazed to see its performance. I shall come up with what types of trades I do with this system in my next post and I have another DIVERGENCE filtering system which I call 1-2-3 system. That one’s performance is much higher than this one…That one gives me minimum 3:1 RR when that is successful and amazing thing is that is successful 75% or more. I am not sure still whether I shall share it or not.
Need more explanation probably for newbies.. on your break divergence-out entry. Don't u think that it will be a tricky job to identify the entry point ?
Have u made any extra indicator to identify the Entry point ?
After I get divergence in HIGHER TF, I go for shorter TF, there I trade with same direction with the higher TF. No I don't use any other kind of extra indicator. When I am trading in 1H or more I give it time to retrace for some candle, and I find out for good PRICE ACTION in candle formation. That's it. Thank you for comments Brother.