Volatility Arbitrage

Volatility Arbitrage is a trading strategy that attempts to capitalize on differences between the expected volatility of a financial instrument and its implied volatility derived from options pricing.

Understanding Volatility Arbitrage

Volatility arbitrage is based on the premise that there can be disparities between anticipated market behavior and the prices of options. Traders executing this strategy aim to profit from these discrepancies by buying and selling options and/or the underlying asset.

Key Components

• Implied Volatility: This is the market’s forecast of a likely movement in a security’s price, reflecting the volatility that options traders expect in the future.
• Realized Volatility: This is the actual volatility observed in the market over a specific period, which can differ significantly from implied volatility.
• Options Pricing Models: Models such as the Black-Scholes model are used to calculate the theoretical value of options based on factors including the underlying asset’s price, strike price, time to expiration, and volatility.
• Delta Hedging: A technique used in volatility arbitrage to control risk by balancing the position to ensure that changes in the price of the underlying asset do not significantly impact the overall position.

Executing Volatility Arbitrage

1. Identifying Opportunities: Traders monitor for instances where the implied volatility of options is significantly higher or lower than the historical or expected future volatility of the underlying asset.
2. Position Setup: Traders will typically establish positions by buying options that are undervalued (lower implied volatility) while simultaneously selling options that are overvalued (higher implied volatility).
3. Hedging Risk: To offset potential losses from movements in the underlying asset’s price, traders implement hedging strategies, such as delta hedging.

Real-World Example

Suppose a trader analyzes a stock that shows an implied volatility of 30% through its options pricing. However, after performing a thorough assessment, the trader determines that the stock’s historical and anticipated volatility is only 20%.

– The trader buys options priced with the lower implied volatility (20%) and simultaneously sells options priced with the higher implied volatility (30%).
– As the market stabilizes and the true volatility aligns more closely with the expected volatility, the trader may see a profit from the changes in option prices as the discrepancies in volatility adjust.

Through this strategy, the trader can benefit from the relative movements of implied and realized volatility, potentially achieving profits in a market environment that is not aligned with their expectations.