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.

BREAKING DOWN '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.

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RELATED FAQS
  1. How does implied volatility impact the pricing of options?

    Learn about two specific volatility types associated with options and how implied volatility can impact the pricing of options. Read Answer >>
  2. What is an option's implied volatility and how is it calculated?

    Learn what implied volatility is, how it is calculated using the Black-Scholes option pricing model and how to use a simple ... Read Answer >>
  3. Can delta be used to calculate price volatility of an option?

    Learn how implied volatility is an output of the Black-Scholes option pricing formula, and learn about that option formula's ... Read Answer >>
  4. What is the relationship between implied volatility and the volatility skew?

    Learn what the relationship is between implied volatility and the volatility skew, and see how implied volatility impacts ... Read Answer >>
  5. How is implied volatility for options impacted by a bearish market?

    Learn why implied volatility for option prices increases during bear markets, and learn about the different models for pricing ... Read Answer >>
  6. How is implied volatility used in the Black-Scholes formula?

    Learn how implied volatility is used in the Black-Scholes option pricing model, and understand the meaning of the volatility ... Read Answer >>
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