how volatility arbitrage works
because options pricing is affected by the volatility of the underlying asset if the forecasted and implied volatilities differ there will be a discrepancy between the expected price of the option and its actual market price a volatility arbitrage strategy can be implemented through a delta neutral portfolio consisting of an option and its underlying asset for example suppose a trader thought a stock option was underpriced because implied volatility was too low in that case they may open a long call option combined with a short position in the underlying stock to profit from that forecast if the stock price doesn t move and the trader is correct about implied volatility rising then the cost of the option will increase alternatively if the trader believes that the implied volatility is too high and will fall they may decide to open a long position in the stock and a short position in a call option assuming the stock s price doesn t move the trader may profit as the option falls in value with a decline in implied volatility a volatility arbitrage strategy is complex and carries risk for traders but it can be implemented using a delta neutral portfolio consisting of an option and its underlying asset special considerationsthere are several assumptions a trader must make which will increase the complexity of a volatility arbitrage strategy first the investor must be right about whether implied volatility is over or under priced second the investor must be correct about the amount of time it will take for the strategy to profit or the time value erosion could outpace any potential gains finally if the underlying stock price moves more quickly than expected the strategy will have to be adjusted which may be expensive or impossible depending on market conditions investopedia does not provide tax investment or financial services and advice the information is presented without consideration of the investment objectives risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors investing involves risk including the possible loss of principal 