Volatility arbitrage is a strategy that aims to maximize profits by considering the difference between an option’s implied volatility and its future realized volatility, within a delta-neutral portfolio. The investor carefully evaluates predictable factors that could affect the risk associated with an option in the future, and looks for options with different levels of volatility to offset each other. The strategy requires accurate predictions and careful consideration of relevant factors to generate significant returns.
Sometimes referred to simply as arbitrage, volatility arbitrage is a strategy that has the goal of getting the most profit from owning a given security. This is managed by considering the difference between an option’s implied or understood volatility and the future realized volatility of that same option, assuming the option is part of a delta-neutral portfolio. Employing this approach involves carefully considering the risk or volatility associated with the underlying security rather than simply following the current price and prevailing market conditions.
Within a delta-neutral portfolio, there is a balance between the positive and negative deltas associated with securities. This simply means that the risks associated with some of the securities are offset by the risk factors of the other securities, effectively creating a risk factor for the overall portfolio that amounts to more or less zero. In theory, if some of the assets lose value, that is offset by the other assets increasing in value, allowing the portfolio to at least maintain its value, and possibly even post some amount of profit.
Volatility arbitrage works very well in this type of portfolio structure. By carefully evaluating the predictable factors that could have an effect on the risk associated with an option in the future, it is possible to determine if a given investment is a good fit for the portfolio, or if it has the potential to offset that balance. Many different events can be considered when creating a future volatility forecast, including disputes over patents held by the issuing entity, the results of new product trials, or changes in demand that affect the earnings of the issuing corporation. the guarantee. An investor may even consider the possible resignation of key figures within the company’s hierarchy as part of the volatility arbitrage process.
Once this future volatility is determined, the investor can begin looking for a different option that presents a different level of volatility, allowing one to offset the other. If the second option has lower volatility than the first, the investor will hedge the underlying security to maintain the desired balance. In situations where the volatility is higher, the investor can sell the option, once again with the underlying security.
An investor using a volatility arbitrage strategy will return when the realized volatility of that option is close to his predictions, and not in the direction of the implied volatility in the market. This approach can be used constantly as new holdings are bought and old ones sold in response to the degree of balance the investor wishes to maintain in the portfolio. As with many investment strategies, a volatility arbitrage requires careful consideration of the relevant factors by the investor, and accurately projecting the effects of those factors on the securities in question. If accurate predictions are not made, the investor may lose a significant amount of income, instead of generating significant returns.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
