Article by: Keith Loggie
Published by: Standard & Poor’s
Date: Jul 2008
“In broad terms, volatility arbitrage can be used to describe trading strategies based on the
difference in volatility between related assets, for instance the implied volatility of two
options based on the same underlying asset. However, the term is most commonly used
to describe strategies that take advantage of the difference between the forecasted future
volatility of an asset and the implied volatility of options based on that asset. This
strategy is often implemented through a delta neutral portfolio consisting of an option and
its underlying asset. The return on such a portfolio will be based not on the future returns
of the underlying asset but rather on the volatility of its future price movements. Buying
an option and selling the underlying results in a long volatility position, while selling an
option and buying the underlying results in a short volatility position. A long volatility
position will be profitable to the extent that the realized volatility on the underlying is
ultimately higher than the implied volatility on the option at the time of the trade.”
Full article (PDF): Link