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. Catastrophe Equity Put (CatEPut)

    Catastrophe equity puts are used to ensure that insurance companies ...
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

    Options and Roth IRAs: Do's and Don'ts

    A breakdown of the do's and don'ts of trading options in a Roth IRA.
  5. Options & Futures

    5 Secrets You Didn't Know About Roth IRAs

    Between its generous tax benefits at retirement and no required minimum distributions, a Roth IRA is well worth considering if you're eligible to have one.
  6. Forex Strategies

    The 10 Riskiest Investments

    Investors seeking high returns must also be prepared for high risk. Here are ten of the riskiest investments available.
  7. Options & Futures

    Trade Covered Calls On High Dividend Paying Stocks

    We explain the risks, rewards, timing, and profit and loss considerations for covered calls with dividend stocks.
  8. Options & Futures

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  9. Investing

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  10. Mutual Funds & ETFs

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?

You May Also Like

Hot Definitions
  1. Loan-To-Value Ratio - LTV Ratio

    A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage.
  2. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  3. Asset Class

    A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same ...
  4. Fiat Money

    Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat ...
  5. Interest Rate Risk

    The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between ...
  6. Income Effect

    In the context of economic theory, the income effect is the change in an individual's or economy's income and how that change ...
Trading Center