Volatility Arbitrage: Overview & Concerns

Volatility Arbitrage is a form of statistical arbitrage used in options trading. This trading technique exploits the difference between an option’s implied volatility and the underlying asset’s actual volatility. Vol Arb is usually implemented in a delta-neutral portfolio that includes an option and the asset on which it is based and typically yields positive results during periods of uncertainty for traders who are long volatility.

What Is Volatility Arbitrage?

Volatility arbitrage is a statistical arbitrage strategy that aims to generate profits from the difference arising from the implied volatility of options and a trader’s predicted volatility of its underlying assets. Notice the word prediction — volatility arbitrage is not a riskless arbitrage as we’ve seen with other types of arbitrage.

Volatility traders attempt to capture profit when they believe there is a discrepancy between the implied volatility and predicted volatility. Traders who buy calls and puts are long volatility and will make money if the volatility of the underlying is higher than the implied volatility. Traders who sell volatility make money collecting premium from selling the options to the long vol traders hoping the volatility will be less than expected.

Professor Damodaran demonstrates how to value options for those interested in options pricing dynamics and the Black Scholes option pricing model.

How Volatility Arbitrage Works

Volatility arbitrage is usually accomplished in a delta-neutral portfolio that comprises an option and its underlying asset. Delta measures the extent to which an option’s price changes following the change in the market price of its underlying security. A delta-neutral portfolio doesn’t take a directional bet on the market. Instead, the trade is on higher or lower realized volatility than implied volatility. But before we discuss that, let’s explore what it means to be delta-neutral by example.

A rise in the asset price results in a higher value for the associated call option, the delta of a call option lies in the range of 0 to 1. In contrast, the delta of a put option lies in the range of -1 to 0 because a higher asset price leads to a lower value of the related put option.

To ensure delta-neutrality, traders must balance their positions by hedging. Long vol traders or traders who buy puts or calls can short more shares if the price rises and repurchase shares to lower the hedge if the price falls. This strategy compels them to buy at a lower point and sell at a higher one and can make great returns during volatile times. For traders with short volatility through selling put or call options, this volatility can be expensive. They hope that the cost of the premium collected is higher than the cost of hedging.

Patrick Boyle gives a great tutorial on volatility arbitrage.

There can be unlimited permutations for volatility arbitrage strategies because it is a statistical arbitrage, and statistical models can develop various approaches, but the overall premise is the same.

Assumption of Volatility Arbitrage

Volatility Arbitrage works on certain assumptions without which traders cannot implement it successfully.

  • Firstly, the investor must be accurate in their prediction about the implied volatility being too high or too low, causing the option to be overpriced or under-priced.
  • Secondly, the investor must accurately predict the amount of time it would take for profit to be realized through this strategy, or time decay can eclipse the potential gains.
  • Thirdly, there must be flexibility in adjusting the strategy if the underlying asset’s price changes more rapidly than expected.

Pros & Cons of Volatility Arbitrage

Volatility Arbitrage is not a typical risk-free arbitrage strategy. While there are a lot of risks associated with Vol Arb, it also brings in a couple of benefits for the traders.

Volatility Arbitrage Benefits

  1. Uncorrelated with standard assets: The strategies are typically uncorrelated with traditional investments. Additionally, long vol strategies have demonstrated strength in challenging market conditions. Using a Volatility trading strategy in a diversified portfolio has improved the portfolio’s overall performance, especially in market turmoil.
  2. Beneficial during phases of high volatility: As we’ve seen, long vol strategies do well when volatility increases, which adds profit when many other return streams do not.
  3. Ability to make significant gains in major market movements: In some instances, long vol strategies have also outperformed other market strategies in phases of high momentum. Also, there is evidence that these strategies haven’t lowered the portfolio’s performance in standard market conditions.

Volatility Arbitrage Risks

  1. Imbalance in movement while using a single underlying asset: One of the most significant risks to the Volatility Arbitrage strategy arises while using single stocks. Suppose there is a substantial movement in the short premium position of the underlying asset, and the long premium part doesn’t match up to it; there is an imbalance.
  2. Inaccurate forecasts: The primary key to this strategy’s success is accurately forecasting volatility. However, in the practical sense, it might not always be possible. The predictions can go astray for several reasons, such as:
    • Unpredictable earnings
    • Speculation over M&A
    • Patent-related disputes
    • Labor Unrest
    • Clinical trial results
  3. The occurrence of black-swan events: For short vol strategies, a “black swan” event means any adverse event or unpredictable circumstance that can significantly impact the returns. This is because of the correlation between the implied volatilities amongst the assets in a portfolio.

Long Term Capital Management (LTCM), a hedge fund management firm with assets over $126 billion, famously used the volatility arbitrage strategy coupled with other arbitrage strategies. As arbitrage trades usually generate low levels of returns, LTCM is traded with a lot of leverage. Its high power and a “black swan” event-the Russian Financial Crisis, led to its major failure in 1998.

  1. Time-decay can offset potential profits: The existence of time value erosion, which can negate the potential benefit of long volatility, is also a significant headwind for volatility arbitrage.
  2. Not a true economic arbitrage: Volatility arbitrage is not an ” economic arbitrage” in the intrinsic sense. This means it is not a risk-free profit opportunity. Vol Arb depends totally on forecasting the direction of implied volatility.
  3. Continuous portfolio rebalancing is challenging: Vol Arb relies on maintaining a delta-neutral portfolio over time. To ensure that, an arbitrageur has to constantly rebalance the portfolio, also known as Gamma Hedging. However, continuous portfolio rebalancing is quite impractical and very expensive due to high transaction fees. On the other hand, if a trader only rebalances periodically, it might result in an imperfect hedge and expose the portfolio to delta risk.

Top Volatility Arbitrage Funds

For those interested in taking advantage of volatility arbitrage diversification without developing your own [algorithmic trading system/algorithmic-trading-is-it-worth-it), the below Volatility Funds offer exposure to volatility in more than one form.

The movement of these funds are diametrically opposed to the broader market movements. This is one of the main reasons these funds are mainly used by traders who wish to exploit and profit from sharp downturns in the market.

  • Stone Ridge High Yield Reinsurance Risk Premium Fund
  • ABR 75/25 Volatility Fund
  • ABR 50/50 Volatility Fund
  • Navigator Sentry Managed Volatility Fund
  • Rydex Strengthening Dollar 2x Strategy Fund
  • iPath Series B S&P 500 VIX Short-Term Futures ETN
  • ProShares VIX Short-Term Futures ETF
  • iPath S&P 500 Dynamic VIX ETN
  • Logica Funds
  • Lynx Arbitrage Volatility Arbitrage Fund

Volatility Arbitrage Resources

Many resources can help you to understand the nuances of Volatility Arbitrage better. These include blogs, journals, research papers, podcasts, and YouTube Videos. Here are some of my favorites:

Should You Arbitrage Volatility?

Volatility Arbitrage is not an economic arbitrage in the true sense; hence you cannot consider it a perfectly risk-free phenomenon.

There is enough evidence to suggest that long vol strategies have yielded promising results, particularly during high volatility and downturns.

However, you must ensure accurate forecasts of the underlying assets’ price volatility and constantly monitor your positions to earn profits from Volatility Arbitrage.

I believe it makes sense to add these volatility arbitrage strategies to your portfolio of strategies if they provide positive uncorrelated expectancy.

The Bottom Line

Volatility Arbitrage is not an economic arbitrage in the true sense; hence you cannot consider it a perfectly risk-free phenomenon.

There is enough evidence to suggest that long vol strategies have yielded promising results, particularly during high volatility and downturns.

However, you must ensure accurate forecasts of the underlying assets’ price volatility and constantly monitor your positions to earn profits from Volatility Arbitrage.

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