Volatility Arbitrage - How does it work? - Options Trading Lessons

What is Volatility Arbitrage?Volatility arbitrage is a trading strategy that attempts to profit from the difference between the forecasted price-volatility of an asset, like a stock, and the implied volatility of options on that asset.These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link. https://amzn.to/2WIoAL0 Check out our website http://www.onfinance.org/Follow Patrick on twitter here: https://twitter.com/PatrickEBoyleHow does Volatility Arbitrage Work?The price of an option is driven by the volatility of the underlying asset. If the forecasted and implied volatilities differ, there will be a discrepancy between the expected price of the option and its actual market price.A volatility arbitrage strategy can be implemented through a delta-neutral portfolio consisting of an option and its underlying asset. For example, if a trader thought a stock option was underpriced because implied volatility was too low, they may buy a call option and combine that with a short position in the underlying stock to profit from that forecast. If the price of the stock doesn't move, but the implied volatility used to price that option rises, then the price of the option will rise. Even if this does not get recognized by the market, but the stock realizes higher volatility than was implied in the initial price, the trading strategy explained in the video will generate a profit for the trader.Alternatively, if the trader believes that implied volatility is too high and will fall, then they may decide to take a long position in the stock and a short position in a put option. Assuming the stock's price doesn't move, the trader may profit as the option falls in value with a decline in implied volatility.There are several assumptions a trader must make, which will increase the complexity of a volatility arbitrage strategy. First, the investor must be right about whether implied volatility really is over- or underpriced. Second, the investor must be correct about the amount of time it will take for the strategy to profit or time value erosion could outpace any potential gains. Finally, if the price of the underlying stock moves more quickly than expected the strategy will have to be adjusted, which may be expensive or impossible depending on market conditions. Learn more about your ad choices. Visit megaphone.fm/adchoices