Risk reversal

The simultaneous purchase of an out-of-the-money call (put) and the sale of an out-of-the-money put (call), usually with no up-front premium.

The Options bought and sold will have the same notional size and pre-defined maturity, and the deltas will typically be set to 25%.

According to Black-Scholes, the purchase and sale of Options with similar deltas (and so out-of-the-money forward to the same extent) should be zero cost. In practice, the market favours one side over the other.

In the simplest case, the implied volatility of out-of-the-money puts and calls of the same strike price and maturity date are different, and the extra cost of the favoured side is commonly known as the risk reversal spread.

This spread reflects the market's perception that the relevant probability distribution is not symmetrical around the forward, but skewed in the direction of the favoured side.

Another way of interpreting this is to say that implied volatility is correlated with spot, which is impossible in a Black-Scholes world.