Volatility arbitrage is a trading strategy that seeks to capitalize on 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 involves various risks including the timing of holding positions, potential price changes of the asset, and uncertainty in the implied volatility estimate.
Key Takeaways
- Volatility arbitrage is a trading strategy used to profit from the difference between forecasted future price volatility and the implied volatility of options based on an asset, such as a stock.
- Investors must accurately determine whether implied volatility is over-or under-priced when considering a trade.
- If the underlying stock price moves faster than an investor anticipated, the strategy must be adjusted; such adjustments could be either impractical or costly depending on market conditions.
- If a trader believes a stock option is underpriced because implied volatility is perceived as too low, they may consider opening a long call option combined with a short position in the underlying stock to profit from the forecast.
- Hedge fund traders often study volatility arbitrage to discover profitable trades.
How Volatility Arbitrage Works
Because options pricing is affected by the volatility of the underlying asset, any discrepancy between forecasted and implied volatilities results in a difference between the expected price of the option and its actual market price.
A volatility arbitrage strategy can be executed via a delta-neutral portfolio, which includes an option and its underlying asset. For instance, if a trader suspects a stock option is underpriced due to low implied volatility, they might open a long call option combined with a short position in the underlying stock to benefit from the projected forecast. If the stock price remains steady, and the trader is correct about the rise in implied volatility, the option’s cost will increase.
Conversely, if the trader believes that the implied volatility is excessively high and bound to fall, they might open a long position in the stock and a short position in a call option. In a scenario where the stock’s price stays unmoved, the trader could profit as the option’s value decreases following a decline in implied volatility.
Special Considerations
A trader must account for several assumptions, amplifying the complexity of a volatility arbitrage strategy.
Firstly, the investor needs to determine precisely if implied volatility is over- or under-priced. Secondly, the investor should accurately project the duration that will yield profit from the strategy; otherwise, time value erosion could outpace potential gains.
Lastly, if the underlying stock price moves quicker than anticipated, the strategy must be reconsidered and potentially adjusted, which could be either unrealistic or expensive given market conditions.
Related Terms: arbitrage, delta-neutral, long call option, short position, hedge fund.
