Volatility Arbitrage

In options trading volatility arbitrage is a statistical trading strategy that seeks to benefit from – or arbitrage – the difference between the implied volatility of an option and the expected volatility of the underlying. Vol arb is best executed in a delta-neutral arrangement that enables the trader to have pure exposure to volatility and not be distracted by changes in the price of the underlying. Taking a long position in an option with implied volatility that looks low (i.e. the option is cheap) and a short position to hedge the underlying to form a long volatility position can profit if implied vol plays catch-up and rises before expiry. The same is true in reverse: shorting an option with overpriced vol and going long the underlying i.e. being short volatility, a trader can profit if implied vol reduces to fair value before expiry.