What Is Volatility Arbitrage?
Volatility arbitrage is a trading strategy that attempts to profit from the difference between the forecasted future price volatility of an asset, like a stock, and the implied volatility of options based on that asset.
Volatility arbitrage has several associated risks, including the timing of the holding positions, potential price changes of the asset, and the uncertainty in the implied volatility estimate.
- Volatility arbitrage is a trading strategy used to profit from the difference between the forecasted future price volatility and the implied volatility of options based on an asset, like a stock.
- An investor must be right about whether implied volatility is over-or under-priced when considering a trade.
- Suppose an underlying stock price moves faster than an investor assumed. In that case, the strategy will have to be adjusted, which depending on market conditions, could be impossible, or at the very least, expensive.
- If a trader thinks a stock option was underpriced because implied volatility was too low, they may consider opening a long call option combined with a short position in the underlying stock to profit off the forecast.
- A hedge fund trader might study volatility arbitrage to make trades.
How Volatility Arbitrage Works
Because options pricing is affected 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.
A volatility arbitrage strategy can be implemented through a delta-neutral portfolio consisting of an option and its underlying asset. For example, suppose a trader thought a stock option was underpriced because implied volatility was too low. In that case, they may open a long call option combined with a short position in the underlying stock to profit from that forecast. If the stock price doesn't move, and the trader is correct about implied volatility rising, then the cost of the option will increase.
Alternatively, if the trader believes that the implied volatility is too high and will fall, they may decide to open a long position in the stock and a short position in a call option. Assuming the stock's price doesn't move, the trader may profit as the option falls in value with a decline in implied volatility.
A volatility arbitrage strategy is complex and carries risk for traders, but it can be implemented using a delta-neutral portfolio consisting of an option and its underlying asset.
There are several assumptions a trader must make, which will increase the complexity of a volatility arbitrage strategy.
First, the investor must be right about whether implied volatility is over-or under-priced. Second, the investor must be correct about the amount of time it will take for the strategy to profit, or the time value erosion could outpace any potential gains.
Finally, if the underlying stock price moves more quickly than expected, the strategy will have to be adjusted, which may be expensive, or impossible depending on market conditions.
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