Volatility Arbitrage: What it is, How it Works

What Is Volatility Arbitrage?

Volatility arbitrage is a trading strategy that profits from the difference between forecasted price volatility of an asset, like a stock, and the implied volatility of options based on that asset.

Risks associated with volatility arbitrage include timing of holding positions, potential price changes of the asset, and uncertainty in implied volatility estimate.

Key Takeaways

• Volatility arbitrage is a trading strategy that profits from the difference between forecasted future price volatility and implied volatility of options.
• An investor must determine whether implied volatility is over- or under-priced when considering a trade.
• If the underlying stock price moves faster than expected, adjustments to the strategy may be difficult or expensive.
• A trader may open a long call option with a short position in the underlying stock if they believe a stock option was underpriced due to low implied volatility.
• Hedge fund traders often study volatility arbitrage to inform their trades.

How Volatility Arbitrage Works

Options pricing is influenced by the volatility of the underlying asset. If forecasted and implied volatilities differ, there will be a discrepancy between the expected price of the option and its market price.

A volatility arbitrage strategy can be implemented through a delta-neutral portfolio comprising an option and its underlying asset. For example, if a trader believes a stock option was underpriced due to low implied volatility, they may open a long call option with a short position in the underlying stock to profit from their forecast. If the stock price remains stable and implied volatility rises, the option becomes more expensive.

Conversely, if a trader expects implied volatility to decline because it is too high, they may take a long position in the stock and a short position in a call option. The trader may profit if the stock price remains unchanged and the option’s value decreases with declining implied volatility.

Implementing a volatility arbitrage strategy requires a delta-neutral portfolio and involves complexity and risk for traders.

Special Considerations

There are several assumptions a trader must make, increasing the complexity of a volatility arbitrage strategy.

First, the trader must accurately assess whether implied volatility is over- or under-priced. Second, the trader must predict the time required for the strategy to be profitable, considering potential time value erosion.

Additionally, if the underlying stock price moves more quickly than expected, adjustments to the strategy may be costly or impossible, depending on market conditions.