Valuing Option Risk Reversals and Flies Through Spot–Volatility Dynamics

Summary

The document considers how to judge whether an option risk reversal is fairly valued and how to decide whether a risk reversal or a fly should be bought or sold. It links risk reversal value to vanna, the sensitivity associated with changes in spot and implied volatility, and argues that the structure’s value reflects the expected relationship between volatility and the underlying over the contract’s life. Strong co-movement between spot and implied volatility can support greater risk reversal value if that dynamic is expected to persist.

For practical assessment, the replies frame these structures as relative-value trades: compare current pricing with historical behavior or use forward-looking confidence bands. The discussion does not provide a quantitative model, calibration procedure, or trade rule, and it cautions that apparent dislocations may last a long time. It also leaves the fly’s decomposition into gamma-related components largely unexplained, so the material offers a valuation framework rather than a complete implementation method.

Key ideas

• Risk reversal value depends on expected spot and implied-volatility co-movement over the contract’s life.
• A current spot–volatility relationship matters only to the extent that traders expect it to continue.
• Relative-value analysis can compare current prices with history or with forward-looking confidence bands.
• Historical comparisons and confidence bands both rely on assumptions and may not identify when a dislocation will close.
• The replies do not provide a complete quantitative method for valuing or trading flies.

Tags

# Assessing the value of risk reversal and the fly


# Assessing the value of risk reversal and the fly












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?

## Answer by dm63 (score 1, accepted)

https://quant.stackexchange.com/a/76917

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.

## Answer by user68819 (score 0)

https://quant.stackexchange.com/a/76920

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

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.