Volatility Arbitrage

What Is Volatility Arbitrage?

Volatility arbitrage is a trading strategy that endeavors to profit from the difference between the forecasted future price-volatility of an asset, similar to a stock, and the implied volatility of options in view of that asset.

Volatility arbitrage has several associated risks, including the timing of the holding positions, potential price changes of the asset, and the vulnerability in the implied volatility estimate.

How Volatility Arbitrage Works

Since options pricing is impacted by the volatility of the underlying asset, if the forecasted and implied volatilities vary, there will be an inconsistency between the expected price of the option and its real market price.

A volatility arbitrage strategy can be carried out through a delta-neutral portfolio comprising of an option and its underlying asset. For instance, assume a trader thought a stock option was underpriced in light of the fact that implied volatility was too low. In that case, they might open a long call option combined with a short position in the underlying stock to profit from that forecast. In the event that the stock price doesn't move, and the trader is right about implied volatility rising, then the cost of the option will increase.

On the other hand, assuming that the trader accepts that the implied volatility is too high and will fall, they might choose to open a long position in the stock and a short position in a call option. Expecting the stock's price doesn't move, the trader might profit as the option falls in value with a decline in implied volatility.

A volatility arbitrage strategy is complex and conveys risk for traders, yet it very well may be executed utilizing a delta-impartial portfolio comprising of an option and its underlying asset.

Special Considerations

There are several suspicions a trader must make, which will increase the complexity of a volatility arbitrage strategy.

In the first place, the investor must be right about whether implied volatility is finished or under-priced. Second, the investor must be right about the amount of time it will take for the strategy to profit, or the time value erosion could outperform any likely gains.

At long last, assuming that the underlying stock price moves surprisingly rapidly, the strategy should be adjusted, which might be costly, or inconceivable relying upon market conditions.

Highlights

• Volatility arbitrage is a trading strategy used to profit from the difference between the forecasted future price volatility and the implied volatility of options in light of an asset, similar to a stock.
• A hedge fund trader could study volatility arbitrage to make trades.
• An investor must be right about whether implied volatility is finished or under-priced while thinking about a trade.
• On the off chance that a trader thinks a stock option was underpriced on the grounds that implied volatility was too low, they might consider opening a long call option combined with a short position in the underlying stock to profit off the forecast.
• Assume an underlying stock price moves quicker than an investor assumed. In that case, the strategy should be adjusted, which relying upon market conditions, could be unimaginable, or at any rate, costly.