Risk Reversals and Butterflies

FX options don't trade at a single implied volatility across all strikes — the volatility smile means out-of-the-money puts and calls trade at different levels than at-the-money options. Rather than quoting every strike's volatility separately, FX desks summarize the whole smile with two standard combinations built from equally out-of-the-money put and call pairs, typically at the 25-delta level.

A risk reversal is long an out-of-the-money call and short an equally out-of-the-money put (or vice versa), and its price is quoted as the volatility of the call minus the volatility of the put. A positive risk reversal means calls are bid up relative to puts — the market is paying more to protect against or bet on a rally than a selloff — and its sign and size describe the smile's skew, or lean.

A butterfly is long both the out-of-the-money call and put and short two at-the-money options, and its price is quoted as the average of the two wing volatilities minus the at-the-money volatility. A positive butterfly means both wings trade above the at-the-money level, describing how much extra volatility the market prices into tail moves — the smile's curvature. Together, at-the-money volatility, the risk reversal, and the butterfly let a trader reconstruct an entire approximate smile from just three numbers instead of a full strike-by-strike surface.