Overview of Volatility Arbitrage

Volatility arbitrage, also known as the dispersion trade, has been regarded as a highly complex trade because it requires a lot of statistics and numerous trades. The basic concept for volatility arbitrage is to capture a misrepresentation of the Volatility Index (VIX) for the major components' volatility. The overriding trade is buying a basket of index component options, while simultaneously shorting the index and vice versa.

This trade is performed when the volatility index is lower than it should be according to the component's volatility. When the volatility index is higher than represented by the components, the opposite trade is performed: buy the index and short the options.

Important things to know about before considering volatility arbitrage include gamma and implied volatility versus realized volatility. Knowing the VIX index is also important.

Gamma

This statistic is essentially the second order derivative measuring the sensitivity an option holds to the change in volatility. As volatility goes up, so will the price of options, all else being equal. This premise is what makes volatility arbitrage feasible. The traders who are pricing in a certain volatility at one point or another could be disconnected from the major index volatility, which is what happens before a dispersion trade looks attractive. 

Implied Volatility

The implied volatility is a metric that reflects the pricing of the volatility by traders. Implied volatility is definitely a slippery statistic because it uses a complicated formula. Given that this number is what shows up on professional trading screens, there could be a lot of discrepancy between different calculations based on different formulas. However, realized volatility is a definite number that is based on a trailing number of days equivalent to the standard deviation that is common in other applications of statistics.

What many traders and analysts do is compare implied volatility and current volatility used to price derivatives with realized volatility to show if there is a major discrepancy and even to explain a possible trend or theme in the stock or index. Be aware that implied volatility is the most used variable because it is what essentially makes all the difference in volatility arbitrage.

The VIX Index

Because one of the major trades performed in volatility arbitrage involves the index, knowing how to analyze the VIX is critical to the success in this trade. Know that the VIX index is a commoditized formula that is made readily available for daily consumption, if you will. The intricacies behind this formula are normally understood only by analysts and those who understand the white papers behind it. The methodology for the VIX has changed and can change again, so it is important to know what goes into calculating this volatility index.

It's not a good idea to try to attempt volatility arbitrage because it is so complex. Be sure to read books on it and look into a simplified dispersion trade to attempt to profit from volatility in any market condition.

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