Volatility Arbitrage

Volatility arbitrage is a kind of statistical arbitrage referring to the situation where the ‘vol’ trade is done.In this case, the investors purchase options while shorting the underlying stocks. When going for such a trade, the investors keep in mind the movement correlation, or delta, in the stock price and option price.
It can also be said that the traders and investors earn premiums by option selling and then purchasing the stock.The option markets are considered to be the most liquid market in the world.In the concept of volatility arbitrage, rather than carrying the value of price, volatility refers to the relative measure unit.

According to the concept of volatility arbitrage theory, the traders try to purchase a low volatility and sell a high volatility. The traders involved in the volatility arbitrage can be of two types – long volatility and short volatility. Traders are said to be long volatility when they buy options and they are known as short volatility when they sell options.

The option contract is used to reflect the volatility of the underlying assets for the option traders who are engaged in volatility arbitrage. Due to the put-call parity, whether the traded option is put or call doesn’t matter. This happens because the put-call parity fixes the relationship, which is risk neutral equivalent, between the underlying value asset, a call and a put.
The traders who wish to be engaged in volatility arbitrage should be able to forecast the future realized volatility of the underlying. The traders can do that by determining the daily returns for the particular underlying asset depending on the sample data of the last 252 days. The traders should also consider other factors like whether there will be any unexpected events in the near future or whether the period will be unexpectedly volatile or not. If the trader can predict the market price of an option depending on the implied volatility, we can say that the trader is capable of carrying out the volatility arbitrage trade.

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Last Updated on : 1st July 2013

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