Volatility arbitrage

Volatility arbitrage, a.k.a. Vol Arb, is a trading strategy in which delta-neutral long or short option positions are entered into and maintained, often until the option's expiration. The strategy is driven by differences between the option's implied volatility, and a forecast of the underlier's future realized volatility. In the case where the implied volatility is below the forecast realized volatility, the option is considered cheap, when implied volatility is higher than the forecast volatility, the option is considered expensive. Because of the equivalence of calls and puts (see Put-call parity), it doesn't matter whether the portfolio is composed of calls or puts.

Over the life of a long (short) Vol Arb position, the trader hopes that the underlier's realized volatility to be more (less) than the implied volatility at the time the position is initiated. For instance, if the trader believes that the underlier's realized volatility will be 25% (annualized), but the option is trading on an implied volatility of 30%, then the trader will sell the option and hedge the deltas. As the underlier's price moves, the trader will continually re-hedge the position to maintain delta-neutrality. The trader hopes that:

1. the implied volatility of the option will fall, and
2. the realized volatility of the underlier stays low, at least below 30%, over the life of the option.

In the first case, the price of the option will fall as well which is good for the trader's short position. In the second, the trader profits because the cost to re-hedge the portfolio will be less than what the option will lose in time-value as it approaches expiration. Despite its name, the strategy is not a true arbitrage. Because there is no guarantee on either the option's implied volatility or the underlier's realized volatility, the trader takes on significant risk of loss. In practice, traders seek to diversify across many positions to increase the likelihood of making a profit.