Volatility Arbitrage

AAA

DEFINITION of 'Volatility Arbitrage'

Trading strategies that attempt to exploit differences between the forecasted future volatility of an asset and the implied volatility of options based on that asset. Because options pricing is determined by the volatility of the underlying asset, if the forecasted and implied volatilities differ, there will be a discrepancy between the expected price of the option and its actual market price.

INVESTOPEDIA EXPLAINS 'Volatility Arbitrage'

A volatility arbitrage strategy is generally implemented through a delta neutral portfolio consisting of an option and its underlying asset. A long position in an option combined with a short position in the underlying asset is equivalent to a long volatility position. This strategy will be profitable if the realized volatility on the underlying asset eventually proves to be higher than the implied volatility on the option when the trade was initiated. Conversely, a short position in an option combined with a long position in the underlying asset is equivalent to a short volatility position, which will be profitable if the realized volatility on the underlying asset is ultimately lower than the option's implied volatility.

RELATED TERMS
  1. Underlying Option Security

    An underlying option security is the financial instrument on ...
  2. Delta Neutral

    A portfolio consisting of positions with offsetting positive ...
  3. Volatility

    1. A statistical measure of the dispersion of returns for a given ...
  4. Historical Volatility - HV

    The realized volatility of a financial instrument over a given ...
  5. Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied ...
  6. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
RELATED FAQS
  1. If a long call is owned on the record date of a stock, is the owner of the option ...

    The owner of a long call for a stock is entitled to a dividend only if the option is exercised prior to the ex-dividend date, ... Read Full Answer >>
  2. How can an investor profit from the cyclical nature of the electronics sector?

    An investor can profit from the cyclical nature of the electronics sector in two ways. He can employ sector rotation, shifting ... Read Full Answer >>
  3. What does negative vega mean for credit spreads?

    Greek vega measures an option's sensitivity with respect to a change in the underlying asset's volatility. The vega of an ... Read Full Answer >>
  4. What options strategies are best suited for investing in the banking sector?

    The covered call option strategy allows investors to profit from the banking sector's stability and its track record for ... Read Full Answer >>
  5. What options strategies are best suited for investing in the drugs sector?

    The covered call and long straddle options strategies enable investors to capitalize on the unique characteristics of the ... Read Full Answer >>
  6. What's the difference between a credit spread and a debt spread?

    When trading or investing in options, there are two main option spread strategies, credit spreads and debit spreads. Credit ... Read Full Answer >>
Related Articles
  1. Options & Futures

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  2. Options & Futures

    The ABCs Of Option Volatility

    The mystery of options pricing can often be explained by a look at implied volatility (IV).
  3. Options & Futures

    Option Volatility

    Knowing how the market works in relation to volatility can open a whole new world of opportunity.
  4. Options & Futures

    How To Trade Orange Juice Options

    How do orange juice options work and which factors determine the orange juice valuations? Here's a sneak peak into the world of orange juice options.
  5. Fundamental Analysis

    Explaining the Geometric Mean

    The average of a set of products, the calculation of which is commonly used to determine the performance results of an investment or portfolio.
  6. Options & Futures

    Why Is Best Buy Stock So Volatile?

    We look at why BBY has been so volatile in the past and whether this trend is likely to continue or abate in the future.
  7. Investing Basics

    What is a Stock Option?

    An employee stock option is a right given to an employee to buy a certain number of company stock shares at a certain time and price in the future.
  8. Options & Futures

    Circumvent Limitations of Black-Scholes Model

    Mathematical or quantitative model-based trading continues to gain momentum, despite major failures like the financial crisis of 2008-09, which was attributed to the flawed use of trading models. ...
  9. Retirement

    Don't Make These Top 10 Mistakes On Your Roth IRA

    Don't lose out on the benefits of a Roth by contributing too much, breaking rollover rules or making other avoidable errors.
  10. Trading Strategies

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.

You May Also Like

Hot Definitions
  1. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  2. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  3. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
  4. Brand Equity

    The value premium that a company realizes from a product with a recognizable name as compared to its generic equivalent. ...
  5. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. 2. A situation where sellers have ...
Trading Center