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Sometimes referred to simply as vol arb, volatility arbitrage is a strategy that has the goal of earning the most benefit from the possession of a given security. This is managed by considering the difference between the implied or understood volatility of an option 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 going by the current price and the prevailing market conditions.
Within a delta-neutral portfolio, there is a balance between the positive and negative deltas associated with the securities. This simply means that the risks associated with some of the securities are offset by the risk factors of the other securities, effectively creaing a risk factor for the overall portfolio that amounts more or less to zero. In theory, if some of the assets lose value, that is offset by the other assets that increase in value, allowing the portfolio to at least maintain its worth, and possibly even post some amount of gain.
Volatility arbitrage works very well in this type of portfolio structure. By carefully evaluating 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 potential to offset that balance. Many different events can be considered in creating a future volatility forecast, including disputes over patents held by the issuing entity, the results of trials on new products, or shifts in demand that impact the earnings of the corporation that issued the security. 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 to look for a different option that presents a different level of volatility, allowing one to offset the other. If the second option has a 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, again hedging with the underlying security.
An investor using a volatility arbitrage strategy will realize a return when the realized volatility of that option moves closer to his or her predictions, and not in the direction of the volatility implied by the market place. This approach can constantly be utilized as new holdings are bought and older 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 relevant factors on the part of the investor, and accurately projecting the effects of those factors on the securities in question. Failure to make accurate predictions can cause the investor to lose a significant amount of revenue, rather than result in the realization of significant returns.