Volatility Arbitrage is a concept of statistical arbitrage mostly used in alternative trading. This trading method requires some skill or knowledge to exploit the deviation or divergence among the choices caused by erratic or variation in the fundamental asset.
The concept of Volatility arbitrage is as a statistical arbitrage is employed as a plan of action intended to accomplish a specific goal by using the diversion between the implied variation of choice and estimated or foretold volatility of the fundamental asset.
There are most cases where this prediction becomes doubtful. When the condition of the volatility of the fundamental asset becomes uncertain or without conviction, it portrays that the goal is uncertain or ambiguous in predicting the volatility, the holding selection timing, and the fundamental asset’s value variation are risks having partial status or privileges. with volatility arbitrage.
Furthermore, Volatility Arbitrage produces progressive outcomes when there is incremental volatility. This drives uncertainty for dealers who possess long volatility arbitrage.
Most Volatility dealers try to predict gain with the assumption that there is a discrepancy between the implied volatility and the estimated volatility.
These Traders who desire to purchase calls and puts for long volatility will ensure that any money made will depend on the prediction that the volatility of the fundamental should be higher than the implied volatility.
Conversely, one who gains a livelihood from trading goods offers for sale volatility to make more profit. Aspect from the sales of volatility, a trader can also be entitled to the collection of premium from the sales of the options to the traders in anticipation that the volatility will be less than the anticipated value.
How Volatility Arbitrage Works
Volatility arbitrage is mostly achieved or performed using a delta-neutral portfolio, the term delta-neutral portfolio consists of an option and its fundamental asset.
Delta estimates the unit size or the metric in which the value of the option fluctuates depending on the variation in the market value of its corresponding fundamental security.
One peculiar feature of the delta-neutral portfolio is that it takes a non-directional degree of certainty on the market.
Rather, scenarios that the trade becomes higher or lower depending on two determinants that are implied volatility and actual volatility.
For example, if there is an increase in the value of the asset and this leads to a corresponding increase in the value of the associated call option, then the delta of a call option will be in the range of 0 to 1.
On the other hand, if there is a decrease in the value of the asset and this leads to a corresponding decrease in the value of the associated call option, then the delta of a call option will be in the range of -1 to 0. The assumption is that the higher the value of the asset, the lower the value of the related put option.
In other words, when traders who practice a volatility arbitrage strategy seek options mostly with implied volatility, it automatically means that the volatility will be reasonably large having noticeable or major effects either higher or lower than the anticipated value volatility of the underlying assets.
Let’s look at another scenario
If a trader assumes that the implied volatility of an option is perceived as having a lower value, quantity, or worth than what it has.
It indicates that the stock has a lower value as such the trader has the legal right to open a long position for the call option and close the underlying asset to hedge.
This systematically forms an arbitrage position and preserves the portfolio delta neutrally. In the business of trading, the dealer is often referred to possess “long volatility”, which indicates that the stock can not be altered but remains in an original state of stock price.
This condition is mostly applicable when the implied volatility raises or grows gradually and the option shifts to a favorable value causing the trader to make more profits and vice versa.
S = Price of the underlying asset (at the same class as the European put)
C = Price of a European call option
PV[K] = Present value of the strike price (K), discounted at the risk-free rate from the expiration date of the options.
To truth about volatility, arbitrage is that it earns money for necessities using a stipulation or condition by generating an opportunity to procreate risk-free trading results.
Profit is made with business the minor or second proposition in a categorical syllogism as such the dealer takes for granted, or supposes a business without proof, a supposition, using an unwarrantable claim which includes the assumptions that the value of the option is overvalued or undervalued, the adequate timing for determining the status, and the value of the volatility of the underlying asset.
Erroneous or inappropriate estimates can result in “time value erosion” and strategy adjustments having a high price or cost and affecting the profit over time.
The option status for the volatility arbitrage specific goal can signify either calls or puts. When a dealer desires to long or short volatility, he has the right to long or short either a call or a put and generates similar outcomes.