What is volatility arbitrage?
A trading method known as volatility arbitrage seeks to make money by taking advantage of the discrepancy between the implied volatility of options based on an asset (such as a stock) and the asset’s predicted future price volatility.
The timing of holding positions, possible changes in the asset’s price, and the imprecision of the implied volatility estimate are some risks connected with volatility arbitrage.
The Operation of Volatility Arbitrage
There will be a difference between the option’s projected and actual market prices because the underlying asset’s volatility influences option pricing if the forecasted and implied volatility are different.
An option and its underlying asset may be included in a delta-neutral portfolio to perform a volatility arbitrage strategy. Let’s say, for instance, that a trader believed a stock option was undervalued due to excessively low implied volatility. To benefit from that prediction, they may initiate a long-call option with a short position in the underlying stock. The option’s price will rise if the stock price stays unchanged, and the trader’s prediction of growing implied volatility will pass.
Alternatively, the trader may choose to establish a long position in the stock and a short position in a call option if they think the implied volatility is excessive and will decline. If the stock price stays the same, the trader stands to gain as the implied volatility of the option decreases and its value decreases.
A delta-neutral portfolio comprising an option and its underlying asset may be used to execute a volatility arbitrage strategy, which is risky and sophisticated for traders.
Special Considerations
A trader’s volatility arbitrage approach will get more sophisticated due to the many assumptions they must make.
The investor must be correct to determine whether implied volatility is overpriced or underpriced. Secondly, the investor must accurately estimate the strategy’s time horizon; otherwise, temporal value loss may outstrip prospective returns.
Finally, depending on the state of the market, it may be costly or difficult to modify the approach if the underlying stock price moves faster than anticipated.
Conclusion
- A trading technique called volatility arbitrage is used to make money on the discrepancy between the implied volatility of options based on an asset, such as a stock, and the projected future price volatility.
- When considering a transaction, an investor must be correct about whether implied volatility is over- or under-priced.
- Let’s say the underlying stock price rises faster than an investor anticipated. The approach will then need to be modified, which may be costly or, depending on the state of the market, impossible.
- A trader may initiate a long call option with a short position in the underlying stock to benefit from the prediction if they believe the implied volatility was too low and the stock option was underpriced.
- To make bets, a hedge fund trader may research volatility arbitrage.
