Arbitrage is a term used in the context of trading to describe the simultaneous buy and sell actions of an asset in separate markets. These assets need not necessarily be the same, and one of them could be in the form of a derivative. The difference in pricing for the asset/derivative results in a benefit.

There are different kinds of arbitrage. One such example is statistical arbitrage. This method of arbitrage involves wide use of data and statistics to tap into movement of price.

If you are wondering what is volatility arbitrage and how is it defined, volatility arbitrage is all about leveraging the difference between an option’s implied volatility and an asset’s predicted future price volatility. But, what exactly is implied volatility? It is the forecast of a likely movement in the price of a security. With changing expectations, there are similar changes in the option’s premium. The implied volatility will increase as the demand for an option goes up.

Volatility arbitrage strategy, delta and options trading

The pricing of options is impacted by the volatility of the asset underlying. So, if the implied and forecasted volatilities vary, a gap between the price that is being expected and actual price in the option’s price in the market ensues. It is this gap that is leveraged by a trader.

Volatility arbitrage strategy can be put to use in the context of a  portfolio that is delta neutral. Delta is the ratio of change in an underlying asset’s price and change in the option or derivative’s price. When options are used to trade volatility, the delta aspect of the trade needs to be taken into account. You can create a delta neutral position by balancing delta ratios of call and put options.

Delta neutral trading implies building positions that are not responsive to minor price changes of the stock underlying. This means, whether the stock rises or falls, the position retains value and doesn’t go up or down in price. This kind of trading strategy is usually used by option traders who don’t want any sort of directional bias or risk.

If you are wondering why a trader would wish to have a position that is not responsive to price movements of the asset underlying, here’s the answer: even if the position is not reacting, it still benefits from factors like decay of time and changes in implied volatility.

Because an option’s delta changes with time, there is a need for a regular rebalancing to ensure delta neutrality. The rebalancing of the trades can be done by using the volatility arbitrage strategy.

How does volatility arbitrage work?

Volatility arbitrage strategy would mean looking at options that have implied volatility much greater or lesser than the forecast volatility of the price of assets underlying. If the stock option’s volatility is underpriced, you can go long on the call and take the short position for the underlying asset. This way the delta neutrality is maintained. When the implied volatility goes up, and the option increases to the fair value, you benefit. Fair value is the actual true value of an asset that is agreed upon by both buyer and seller.

In another scenario, if the stock option’s price is overvalued because implied volatility has been overestimated, you can go short on the call and buy the asset underlying. If the forecast turns out to be correct and the price of the stock remains unchanged, the option drops to the fair value, and the trader benefits.

Risks involved

However, it helps to keep in mind that there are still risks inherent in volatility arbitrage. The risks are present because a trader must make correct assumptions and many of them at that. These include the overvaluation or undervaluation of an option, the timing for holding a position, the change in price of the asset underlying. Any wrong estimate can lead to erosion of time value. Any trader who takes up this kind of arbitrage as a strategy should always be mindful of the risks.

Conclusion

The answer to what is volatility arbitrage is that it is a kind of statistical arbitrage strategy that tries to gain from the difference between an asset’s forecasted price volatility and the implied volatility of an option based on the asset. This strategy is usually used in the context of delta neutrality. There are risks inherent in this strategy and a lot rides on the trader’s correct assumptions. A good understanding of options, volatility and delta will help a great deal.