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Volatility Arbitrage

Volatility arbitrage is a trading strategy that seeks to profit from differences between the implied volatility of an asset (based on options pricing) and its actual, or realized, volatility. Traders exploit these discrepancies by taking positions in options and the underlying asset. For example, if the implied volatility is higher than the expected future volatility, a trader might short the options and hedge with the underlying asset to capture the difference.

Example

A trader notices that the implied volatility of a stock’s options is much higher than the realized volatility and takes a short position in the options while hedging with the stock to profit from the discrepancy.

Key points

• A trading strategy that exploits differences between implied and realized volatility.

• Involves taking positions in options and hedging with the underlying asset.

• Profitable when there is a significant discrepancy between expected and actual volatility.

Quick Answers to Curious Questions

They capitalize on the difference between implied volatility (from options pricing) and the actual volatility of the underlying asset.

If the realized volatility differs significantly from expectations or the hedging strategy fails, traders can incur losses.

Implied volatility reflects market expectations of future price movements, and discrepancies between it and actual volatility create arbitrage opportunities.