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Am I correct in saying that most stochastic vol models are meant to behave in a way that as atm vol goes up the smile comes down and risk reversals become "less stretched?" - by that i mean say if a 25d RR is trading at 5% for puts when vol is 15%, it would come down from 5% when atm vol goes up to say 20% and go up when atm vol goes down to 10%?

If above is true then why do people keep looking at put vol vs atm ratio in order to initiate some trades at times?

./M

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  • $\begingroup$ I'll think about this a bit more and see if I can come up with a proper answer. In the meanwhile, I think the statement is not always true or at least it's not a linear relationship. For instance, as the ATM approaches zero, if the skew wouldn't flatten then you'd get negative OTM call IVs at some point, which is not possible. So it cannot be a simple linear relationship. $\endgroup$ Apr 30 at 14:15
  • $\begingroup$ Thanks Frido, you are indeed correct that as vol goes down a lot the smile (vov parameter) goes up and both calls and puts should trade over ATM, actually may be my RR example isn't perfect perhaps as its more the smile which goes up or down with level of vol $\endgroup$
    – Macro RV
    May 1 at 21:52

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Your essentially talking about a pitchfork type approach

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    $\begingroup$ Can you explain a bit more about this approach? $\endgroup$
    – Bob Jansen
    Apr 30 at 7:43

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