Arbitrage refers to simultaneous buy-sell actions on an asset in different markets. They do not have to be identical. One of these assets could be a derivative. A benefit is a difference in the pricing of the asset/derivative.
There are many types of arbitrage. Statistical arbitrage is one example. This arbitrage method makes extensive use of statistics and data to track price movements.
You may be wondering what volatility arbitrage means and how it is defined. Volatility arbitrage refers to leveraging the difference in an option's implied volatility and an asset's future price volatility. What is implied volatility, you ask? It's the prediction of the likely price movement of a security. The option's premium can change due to changing expectations. As the demand for options increases, implied volatility will rise.
Volatility of the asset underlying can have an impact on the pricing of options. If the implied and forecasted volatility levels differ, there will be a gap in the price of the option and the actual market price. This gap is what a trader leverages.
A portfolio that is not delta neutral can use volatility arbitrage strategies. The delta is the ratio between the change in an option's or derivative's prices and the change in the underlying asset's. If options are used for trading volatility, it is important to consider the delta aspect. By balancing the delta ratios of call and puts options , you can create a neutral position.
Delta neutral trading means that positions are not affected by minor price movements in the stock underlying. The position doesn't change in value regardless of whether the stock falls or rises. Option traders don't want to be influenced by risk or have a directional bias. This type of strategy is often used.
You might be wondering why traders would want to hold a position that does not respond to price movements for the asset underlying. Here's the answer: even though the position isn't reacting, it still gains from factors such as decay of time or changes in implied volatility.
Regular rebalancing is necessary to maintain delta neutrality, as an option's beta changes over time. Volatility arbitrage is a strategy that allows you to rebalance trades.
A volatility arbitrage strategy is one that considers options with implied volatility that is greater or less than the expected volatility of the assets underlying. If volatility in the stock option is low, you can take the short position on the call while taking the long position for the underlying assets. This ensures that the delta neutrality is maintained. You will benefit if the implied volatility rises and the fair value increases. The fair value is the true value of an asset as agreed by buyer and seller.
Another scenario is that the stock option's value has been overestimated due to implied volatility. In this case, you can short the call and purchase the asset underlying. If the stock price remains the same, the option will drop to its fair value.
It is important to remember that volatility arbitrage still has risks. These risks exist because traders must make accurate assumptions, and many of them. These include the undervaluation or overvaluation of an option, timing of holding a position and the change in the price of the asset. An incorrect estimate could lead to a loss of time value. Arbitrage is a strategy that traders should be aware of.
What is volatility arbitrage? It is a type of statistical arbitrage strategy which tries to profit from the difference in an asset's forecasted volatility and the implied volatility for an option based upon the asset. This strategy is frequently used when there is no delta neutrality. This strategy has risks and much depends on the trader's right assumptions. Understanding options, volatility, and delta is a huge help.