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Volatility Arbitrage

Candlefocus Editor
Volatility Arbitrage is a trading technique which endeavors to benefit from mispricing between the forecasted price volatility and the implied volatility of a security. The investors are seeking to find securities that are mispriced due to a higher or lower level of implied volatility, while accurately predicting how the security and its underlying asset will move in the future. This strategy involves the purchase of an underpriced option, combined with a corollary hedge, such as a short position in the underlying asset or the writing of a higher priced option. By combining the two positions into a single trade, investors can take advantage of arbitrage opportunities whereby they collect the premium from a mispriced option while mitigating risk of loss due to major price movements.

The volatility of a security is most often estimated through the Black-Scholes model and its derivatives. By examining the model, traders look to identify discrepancies between the projected volatility of an underlying asset, and the volatility implied by the options market. When these conditions show up, traders will often open a long call option position, coupled with a short position in the underlying security. This type of spread is commonly referred to as a ‘volatility spread’ and is designed to capture gains from a price shift in the underlying security that is more volatile than anticipated. It also serves to offset losses if the underlying stock endures a pullback in its price.

Although volatility arbitrage is a popular strategy amongst hedge fund traders, the strategy is not without risk. If market conditions change, the cost to adjust the position or close it out may far exceed any profits. Furthermore, any mis-timing or incorrect analysis of a security’s underlying fundamentals could prove to be disastrous. Lastly, the illiquid nature of volatility spaces may result in trades being filled at an unfavorable price. Despite such risks, volatility arbitrage strategies are used by professional traders on a daily basis and should be taken into consideration by any investors seeking to capitalize on mispriced opportunities.

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