Risk reversals reflect the expectation of the market in terms of the direction of an exchange rate. When used in the correct context, risk reversals can be highly useful for generating potentially profitable overbought and oversold signals.
A risk reversal is a combination of a call and a put option on the same currencym withe the same expiry (one month) and the same sensitivity to the underlying exchange rate. They are quoted in terms of the difference in volatility between the call and the put options. Theoretically, these two options should have the same implied volatility, but in practice they often differ, and this difference can be a useful indicator.
If the number is positive, it shows that the market expects the underlying currency to move upwards in price, and that calls are therefore preferred to puts by the market. Similarly, a negative number shows that puts are preferred to calls, and that the market expects the underlying currency to move downwards in price.
Risk reversals are useful in terms of their ability to poll the market, with a positive risk-reversal number implying that the majority of market participants are voting for a rise in the currency rather than a drop. Therefore, they can be used as a tool for evaluating positions on the forex market.
Although the signals that a risk-reversal system generates are not always completely accurate, they can tell you whether the market is bullish or bearish overall. They convey the most information when they have relatively extreme values. An extreme value could be defined as being one standard deviation beyond the averages of positive and negative values. For negative risk-reversal numbers, you are looking for values of one standard deviation below the average, and for positive numbers you are looking for values one standard deviation above the average.
Risk reversals give contrarian signals when they are at these extreme values. This is because when the entire market is positioned for a rise in a certain currency, it makes it harder for that currency to rise, and much more prone to falling as a result of negative news or market events.
A big positive risk-reversal number implies a situation where the currency is overbought, and conversely a big negative risk-reversal number indicates that it is being oversold. While the buy or sell signals that risk reversals are not perfect, they can at least give you some extra information with which to inform your trades.