Key points

• Volatility arbitrage is a trading strategy used to profit from the difference between the predicted value of future price movements of an asset, such as a stock, and the implied volatility of its options.
• When considering a trade, investors must determine whether implied volatility is overvalued or undervalued.
• If the price of the underlying stock moves faster than the investor expects, the strategy must be adjusted, which may be difficult and to some extent expensive if market conditions permit.
• If traders believe that a stock option is undervalued due to too low implied volatility, they may consider opening a long call option while establishing a short position in the underlying stock to profit from the expectation.
• Hedge fund traders may look into volatility arbitrage for trading purposes.

How volatility arbitrage works

Because option pricing is affected by the volatility of the underlying asset, if the predicted volatility differs from the implied volatility, there will be a difference between the option's expected price and its actual market price.

A volatility arbitrage strategy can be implemented by building a delta-neutral portfolio of options and their underlying assets. For example, suppose a trader believes that a stock option is undervalued because its implied volatility is too low. In this case, they may profit from this expectation by opening a long call option while holding a short position in the underlying stock. If the stock price doesn't move and traders are correct about the increase in implied volatility, the cost of the options will increase.

If traders believe that implied volatility is too high and will fall, they may decide to open a long position on the stock while going short on the call options. Assuming the stock price remains unchanged, traders will likely profit as implied volatility falls because the value of the option will fall with it.

IMPORTANT NOTE: Volatility arbitrage strategies are complex and risky for traders, but can be implemented by building a delta-neutral portfolio of options and their underlying assets.

Special Notes

Traders must make several assumptions that add complexity to a volatility arbitrage strategy.

First, investors must determine whether implied volatility is overvalued or undervalued. Second, investors must accurately judge the time it takes for a strategy to become profitable, otherwise the loss of time value may exceed any potential gains.

Finally, if the underlying stock price moves faster than expected, the strategy will need to be adjusted, which can be very expensive or even impossible under market conditions.

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