Risks of Reversal: One Step Ahead

Imagine that you have the map of the markets, and you know the positions of participants in real-time, this would be nice!

Most of the market makers know exactly who is buying, who is selling, and how much! However, there’s also a problem. While they know the position, there is little they can do to trade against those participants in spot forex. Even if they see a lot of institutions are shorting USDJPY aggressively, market makers cannot turn off their orders, they must provide liquidity and keep buying it from those institutions. Now it does not look as nice as before, but let’s keep going with the story. Now imagine you are a hedge fund manager with 10bn under your management, you are extremely long EURUSD, and you realize a short-term retracement is coming against your position. What would you do? Is it rational to close all positions at once? That creates liquidity for other traders, and you might be cornered into buying it again at higher prices! Well well, compared to this, it looks like being a simple retail trader is not that bad.

These big players protect their large positions against abrupt moves by using options markets. There’s plenty of liquidity and you can create huge positions without moving a huge amount of money. There’s one type of operation, in particular, that is used as an insurance policy and its name is “Risks of Reversal”. In brief, this is when you “Buy a CALL option” (gives you the right but not the obligation to buy the underlying asset at a determined price) and “Sell a Put Option” (you have the obligation to buy the underlying asset at a determined price) and the pricing of the operation is calculated like this:

Risks of Reversal(RR) = PriceCall – PricePut

So we can have positive and negative values for risks of reversal price, and here is the explanation for different scenarios:

RR > 0 – Means that the price of the Call option is greater than the price of the Put option, in other words, markets participants believe that the odds for a move upside are greater than for downside.

RR < 0 Means that price of Call Option is smaller than the price of a Put option, in other words, market participants believe that the odds for a move downside are greater than for upside.

So again why this matters? It matters because this data is updated real-time and reflect feelings of big players for the next market’s movement and it’s the way really big money can move from one side to another without impacting the spot prices. Right now, while I write this article, big players are pricing a big upside for GBPUSD they are buying call options with strike 1.3650, paying the same amount that they are receiving to sell a put option with strike 1.34, so the cost is zero. They only incur in losses if GBPUSD comes below 1.34, so they are strongly believing that the price will rise, at least above 1.3650

While COT data has a 1-week delay, options are real-time, we can see tick by tick what dealers are doing and its very effective in spotting trend reversals.

Here you can see some examples:

  1. GBPUSD (Click to enlarge)

We can see here on 24/01/2018 GBPUSD, after a huge rally closing on 1.4241, the risks of reversal value are at its maximum 0.375, in other words, big money was protecting itself against a move to the upside. If you get COT data for that period, you will see that non-commercials had 99.339 lots long and 66.324 lots short (84661 Long, 58457 short, a week ago). Based on what we discussed before, we reach the following conclusion: Market Markers realized the strength of that move, and at that moment, the market was pricing 1.45 to GBPUSD, the big money started to protect themselves against that anticipated move to 1.45.

The following days we saw risks of reversal price go from positive (protect against a move up) to negative territory (protect against a move down), and the most beautiful thing to see was that happening in previous demand zone (Jun 16, right before Brexit). Market Markers in possession of the info that big specs were taking profit, and some of them adding shorts, starting to protect themselves against a move down, a move that comes very strong driving prices to 1.37630

Look on the table how this move down was anticipated by the options market:

It is a very very powerful tool! This happens all the time. I can give infinity examples, but we have trades to do, so here’s one more on GBPUSD again:

In this case, the options markets start to price the drop 4 days before the top. Market makers have CoT data in real-time folks, they know what retail, institutions, specs, commercial are doing and they truly can predict the markets. So paying attention to their footprints on options markets can help us ride massive trends and avoid huge drawdowns. 


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