New Volatility Arbitrage in Option Trading - Tackling Market Swings

While options trading carries considerable risk, wild market swings further contribute to its volatility. Volatility arbitrage is among the several option trading strategies that can help you tackle market swings and navigate market ups and downs. Read on to learn the various aspects of volatility arbitrage and how to use it to your advantage.

Option Volatility and Pricing

Before understanding volatility arbitrage, it's important to understand option volatility and pricing. Note that an option's price is based on several factors. This includes the underlying asset's price, interest rates, and the option's expiry date. When volatility is high, options become expensive and vice versa. Also, high volatility is likely to change the option's price rapidly, and when volatility is low, there is more stability.

What is Volatility Arbitrage?

Volatility arbitrage is an options trading strategy that aims to benefit from the differences between the option's implied volatility and actual market movements. Options implied volatility means the market's forecast in the movement of an asset's price and shows its expectation for future volatility.

By implementing volatility arbitrage, you can benefit from swings in the market when you expect volatility to differ from market prediction.

Working of Volatility Arbitrage

Implementing volatility arbitrage involves identifying circumstances in which an option's implied volatility is higher or lower than the actual volatility of the underlying asset. If the option's implied volatility is underestimated, you can buy a call option and take a short position. On the other hand, if the option seems to be overpriced due to overestimation of implied volatility, you can sell the call and buy the underlying asset.

Advantages of Volatility Arbitrage

As one of the widely used options trading strategies to minimise risk, prudent usage of volatility arbitrage can offer several advantages. Some of them are as follows:

• Potential for High Returns

You can generate substantial profits from volatility arbitrage if you can accurately predict the discrepancies between expected and actual market volatility.

• Brings Down Market Direction Risk

In traditional trading, profits depend on the asset's price movement in a particular direction. However, volatility arbitrage focuses on price fluctuations and not on direction.

• Effective Hedging Tool

You can effectively bring down the risks associated with sudden and wild price swings through volatility arbitrage. This can help you protect your portfolio from incurring heavy losses.

In Conclusion

Volatility arbitrage is a powerful tool that can help you navigate market swings and benefit from the difference between an option’s implied volatility and the actual one. That said, options trading carries a significant amount of risk, and you should implement any of the option trading strategies after careful analysis.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.