What is volatility arbitrage?

This is a trading strategy that aims to capitalise on the differences between the implied volatility of an option and the actual volatility that’s realised in the future. Volatility arbitrage is normally conducted in a delta-neutral portfolio comprising an option and its underlying asset.

Where have you heard about volatility arbitrage?

Known as ‘vol arb’ in the trade, the volatility of an option and its underlying asset, as opposed to the price, is the key measure for traders who decide to buy at times of low volatility and sell when volatility is high.

What you need to know about volatility arbitrage.

In a delta-neutral portfolio the long and short positions offset each other, effectively creating a risk factor for the overall portfolio that's about zero. So if some assets lose value, in theory that loss is offset by the other assets that increase in value.

A volatility arbitrage strategy works well in this type of portfolio structure. You make a profit if the realised volatility on the underlying asset eventually turns out to be higher than the implied volatility on the option when the trade was initiated. However, if your predictions aren’t accurate, you can lose a substantial amount of money.

Find out more about volatility arbitrage.

For background information, read our definitions of arbitrage and option.