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I understand that risk reversal is a bet on the skew of the implied volatility curve. But when would one have a view on the skew of the curve? I understand that one can have a view on the underlying. (If I think the firm is going to do better, then I go long the underlying stock).

Similarly, I understand when one would have a view on volatility. (If there is going to be an event, but I am not sure about the direction, I can bet on volatility).

But when would one long skew or short skew?

If I have some long positions on TSLA, does it make sense to hedge it with a risk reversal?

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  • $\begingroup$ According to my experience, there are no scenarios where you say: "I'm going to use a risk reversal". Instead, a position like that is naturally born when you pick long or short single options because of other parameters. This process might end up with a risk reversal, but that's just the result and not the cause. $\endgroup$ – Lisa Ann May 23 at 16:19
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Assuming you are purely interested in trading volatility, you would never run a delta position such as this. I could imagine you would want to sell risk reversals (going long puts, going short calls), when you think the expectation of a crash will become higher, in which case put side volatilities tend to go up, and make the position gain

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If you are long TSLA and hedge it with a risk reversal, you have bought a put and sold a call on TSLA with the same expiration and effectively collaring your position. You are limiting your losses at the expense of limiting your gains over the holding period to the expiration of the options.

Some traders will put on the risk reversal with a particular delta in mind. For example, 25 delta calls and 25 delta puts. In this case they would buy the 25 delta put and sell the 25 delta call. Ignoring the cost of carry, the trader will be pay a net premium if the implied vol on the purchased put is higher than the implied vol on the sold call.

Another strategy would be to put the risk reversal on dollar neutral. The trader would pick a strike (say corresponding to 25 delta Call) and sell this call. The would then buy the put where the price is the same as the 25 delta call.

One might put this hedge on if they wanted some downside protection on a position but did not want to pay the full premium of the put.

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  • $\begingroup$ "In this case they would buy the 25 delta put and sell the 25 delta call. The risk reversal will be delta neutral initially." -- There must be a misunderstanding, because the situation you describe has a delta of -50 (-25 from the long put and -25 from the short call). $\endgroup$ – Chris Taylor May 22 at 19:18
  • $\begingroup$ You are correct. I was typing one thing and thinking another (I trade riskies and straddles/strangles and had a momentary lapse.) I will correct. Thanks very much @ChrisTaylor $\endgroup$ – AlRacoon May 22 at 19:27

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