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This is important for traders. What I'm really asking is how do we ascertain if vanna (or dvegadspot) is being valued correctly by the market?

and for the fly, fair fly value will be a combination of risk reversal gamma and vol gamma. But again, how can we analyse that and decide to go long or short?

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Think of the risk reversal as being priced according to the expected vol/spot behavior over the life of the contract. So if you have a market dynamic right now whereby implied vols move significantly and in a highly correlated manner with spot, the risk reversal should have significant value, but only if that sort of behavior is expected for the whole life.

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I'd add..this stuff tends to be relative value- therefore, in context. Caveat, things can remain dislocated for long periods of time. To the best of my knowledge you can only really look historically to ascertain the mispricing, or create some kind of fwd looking confidence bands which have their own assumptions

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  • $\begingroup$ Yes you're right but there must be certain metrics likes of a PM would look at to ascertain the value. For RR yea its about spot vol correlation as dm63 said, which is fairly easy to look at historically. For fair fly value its trickier I think.. I wonder if you can backtest the mid vol of a volswap over time to reflect vol of vol ? $\endgroup$
    – Danny
    Oct 20, 2023 at 18:55

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