The hidden cost in a risk reversal

A risk reversal hedge can be flat vega, small short gamma, and still cost you decay every day.

Here’s the shape of it.

You buy the put and sell the call. You’re long vega on one leg and short vega on the other, so net vega is close to flat. You’re carrying a small amount of short gamma. And you’re paying a little bit of theta.

That theta bill is due to the skew.

The put you’re buying trades on a higher implied vol than the call you’re selling. In one SPY example I use, it was 19 vol on the put and 16 on the call. That’s 3 vols you’re paying away.

As a hedger, I’m not overly concerned about that. It’s the price of the protection, and a few weeks ago I wrote about trading around a risk reversal to claw some of it back.

The bit I’d watch is the skew itself.

Skew tends to trade in a range, just like implied vol does. Sometimes it’s flat, sometimes it’s pumped, and it tends to come back towards the middle over time.

That matters for when you put the hedge on.

If you buy a risk reversal when skew is super pumped and the market then normalises, skew can flatten. The put you own loses some of its extra vol, and the call you sold picks some up. You can take quite a hit on the mark to market, even if the market itself has been pretty calm.

So the hedge didn’t fail, and nothing dramatic happened. You just paid a high price for the shape and then watched that price come back down.

Checking where skew sits in its own range before I put a hedge on is one of the daily habits as part of my framework. What pumped skew looks like. What it can cost you on the way back. When it’s still worth paying anyway or when you'd pick a different hedging structure.

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