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What is Volatility Arbitrage?
Volatility arbitrage is a trading strategy that aims to exploit discrepancies in implied or realized volatility across different financial instruments. It involves taking positions that profit from expected changes in volatility levels rather than directional movements in the underlying asset price.
Volatility refers to the degree of fluctuation or variability in the price of an asset or market. It can be measured using various techniques, such as implied volatility derived from options prices or realized volatility calculated from historical price movements. Volatility arbitrage seeks to identify situations where the implied or realized volatility of an asset differs from its expected or historical levels. This discrepancy can arise due to market expectations, supply and demand imbalances, or mispricing.
Volatility arbitrage strategies can take different forms, including:
- Volatility Spreads: This strategy involves taking offsetting positions in options or other derivatives to capture the difference in implied volatility between different strike prices or expiration dates. For example, a trader may sell overpriced options with high implied volatility and buy underpriced options with low implied volatility.
- Dispersion Trading: Dispersion trading involves trading the spread between the implied volatilities of different assets within the same market or sector. The strategy takes advantage of the expected convergence or divergence of volatilities among related assets, such as index components or correlated stocks.
- Variance Swaps: Variance swaps are derivative contracts that allow investors to trade the volatility of an underlying asset. Volatility arbitrageurs may take positions in variance swaps to profit from expected differences between realized volatility and implied volatility.
Volatility arbitrage strategies often involve complex positions and exposure to various sources of risk, including directional risk, volatility risk, and correlation risk. Effective risk management techniques, such as proper hedging, position sizing, and portfolio diversification, are crucial to mitigate potential losses. It also relies on the assumption that market participants do not accurately price volatility or that the market will correct pricing discrepancies over time. However, due to competition and market efficiency, opportunities for pure volatility arbitrage may be limited and short-lived. Traders need to continuously monitor and adapt their strategies to changing market conditions.
Volatility arbitrage is covered in more detail in module 3 of the CQF program.