July 10 (Reuters) - EUR/USD risk reversals are FX option structures that benefit from volatility in one direction over the other, and in the right environment they can generate steady premium. Just as importantly, shifts in their pricing offer the FX market valuable clues about directional risk sentiment.

FX options are forward-looking instruments that thrive on volatility. Because actual volatility is unknown — yet central to an option’s premium — dealers use implied volatility as a proxy. Risk reversals typically show an implied-volatility premium in the direction where dealers expect volatility to rise, and a discount in the other.

Trading a risk reversal involves owning a strike in one direction and selling a strike in the opposite direction. Buyers of risk reversals want spot to move in that direction, lifting implied volatility and boosting the option’s value. At the same time, the strike they’ve sold should lose value, allowing the entire position to be closed for a profit.

Changes in those directional premiums can reveal shifts in how the market perceives the path of a currency pair — or signal rising risk of a directional break. We saw this in EUR/USD amid fears of a re-escalation in the Middle East conflict this week, with the benchmark 1-month expiry 25 delta risk reversals widening their EUR put over call risk premium (downside over upside strikes) to 0.45 from 0.35. This rise in premium — and the sentiment signal it carried — proved justified, as EUR/USD implied volatility increased from 4.9 to 5.3 as EUR/USD slipped below 1.1400 earlier this week. What's interesting is that despite EUR/USD moving back to the low-mid 1.14's, the 1-month risk reversal has retained that firmer downside strike premium, which suggests the options market remains alert to the risk of more EUR/USD weakness and implied volatility gains.
EUR/USD 25 delta risk reversals


EUR/USD FXO implied volatility


(Richard Pace is a Reuters market analyst. The views expressed are his own)