What are Volatility Arbitrage Strategies?
Trading strategies that attempt to make money on the differences between the forecasted future volatility of an asset and the implied volatility of options based on that asset. Because options pricing is determined 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. In volatility arbitrage, volatility rather than price is used as the unit of relative measure, i.e. traders attempt to buy volatility when it is low and sell volatility when it is high.
Why You Care
A volatility arbitrage strategy is generally implemented through a delta neutral portfolio consisting of an option and its underlying asset. Buying a long position in an option combined with selling a short position in the underlying asset is equivalent to a long volatility position. This strategy will be profitable if the actual volatility on the underlying asset turns out to be higher than the implied volatility on the option when the trade was initiated. On the other hand, a short position in an option combined with a long position in the underlying asset is equivalent to a short volatility position, which will be profitable if the actual volatility on the underlying asset is ultimately lower than the option's implied volatility.
To an option trader engaging in volatility arbitrage, an option contract is a way to speculate in the volatility of the underlying rather than a directional bet on the underlier's price. If a trader buys options as part of a delta-neutral portfolio, he is said to be long volatility. If he sells options, he is said to be short volatility. So long as the trading is done delta-neutral, buying an option is a bet that the underlier's future realized volatility will be high, while selling an option is a bet that future realized volatility will be low.
Because of the put–call parity, it doesn't matter if the options traded are calls or puts. This is true because put-call parity posits a risk neutral equivalence relationship between a call, a put and some amount of the underlier stock, future, or other asset. Therefore, being long a delta-hedged call results in the same returns as being long a delta-hedged put.
Proprietary Trading Desk (Prop Desk),
Hedge Fund Firm,
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