Volatility arbitrage is an advanced strategy used in quantitative trading to exploit differences between the implied and realized volatility of an asset. Here's how volatility arbitrage can be exploited:
Understanding implied and realized volatility
The first step in exploiting volatility arbitrage is to understand the difference between implied and realized volatility.
- Implied Volatility (IV): This is the expected volatility of an asset in the future, as incorporated into the price of options on that asset.
- Realized Volatility (RV): This is the asset's historical volatility, measured using past prices.
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Opportunity identification
When VI is higher than expected RV, this could indicate that options are overvalued. Conversely, if the VI is lower than the expected VR, the options could be undervalued.
Strategy implementation
If a quantitative trader believes that the VI is too high in relation to the future VR, he could:
- Sell options to take advantage of the high premium.
- Buy the underlying asset or use other instruments to hedge against adverse market movements.
Risk management
As with any trading strategy, risk management is essential. Volatility arbitrage is not risk-free, and unexpected market movements can result in losses.
Closing the Position
After a certain period of time, or when market conditions change, the trader may decide to close the position, taking profits or limiting losses.
Conclusion
Volatility arbitrage, when properly exploited in quantitative trading, can offer lucrative opportunities. However, like all trading strategies, it requires thorough research, a good understanding of the market and rigorous risk management.
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