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Volatility Arbitrage

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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 Says

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 Definitions

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    Volatility

    1. A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns ...
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  • Implied Volatility - IV

    The estimated volatility of a security's price. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common ...
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  • Delta Neutral

    A portfolio consisting of positions with offsetting positive and negative deltas. The deltas balance out to bring the net change of the position to zero.
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    • Underlying Option Security

      An underlying option security is the financial instrument on which a derivative's (i.e., an option's) value is based – it provides the price that is used to determine the value of the ...
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    • Historical Volatility - HV

      The realized volatility of a financial instrument over a given time period. Generally, this measure is calculated by determining the average deviation from the average price of a ...
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