Volatility Arbitrage: How to Trade Option Volatility

IV doesn't have to crush you — IF you know how to trade option volatility. Discover how to measure volatility, and how to add volatility arbitration strategies to your trading toolkit.

Justin Nugent

This article was last updated on 10/27/2022.

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Volatility arbitrage. That’s a mouthful. The complicated-sounding nature of the phrase volatility arbitration may be enough to push would-be readers out the door. But if you can stomach a few more multi-syllable words, you should stick around. Volatility arbitration is the bread and butter of many options trading hedge funds & institutions, and it also happens to be one of this writer’s favorite options strategies. That’s because volatility arbitrage forgoes the typical “pick a direction” style of options trading. Instead, volatility arbitration is typically a delta-neutral prediction — meaning that stock price direction doesn’t matter. In volatility arbitrage, the prediction is about the size of the move in the underlying stock, and the effect that move has on implied volatility. This is part of what makes volatility arbitrage such an effective earnings option strategy.

What is Volatility Arbitrage?

Volatility arbitrage is a strategy that predicts a discrepancy between the implied volatility (or the implied move) of an option, and the actual outcome.

The volatility arbitrage strategy attempts to profit from the difference between the forecasted future price volatility of an asset, like a stock, and the implied volatility of options based on that asset.

Investing involves risk — and volatility arbitrage is no exception. Volatility arbitrage has several associated risks, including the timing of the holding positions, potential price changes of the asset, and the uncertainty in the implied volatility estimate.

By understanding the strategy, and becoming familiar with specific data points, option traders can mitigate those risks and put probability on their side.

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How Volatility Arbitrage Works

As we discussed above, volatility arbitrage strategies take two primary forms: long volatility and short volatility.

In a long volatility strategy, traders look at the implied move of the options chain in question and decide that the options are underpricing the relative value. As such, traders may take on any number of long volatility, market-neutral options strategies. Popular choices include straddles and strangles, but some traders may opt to use more nuanced strategies, like long iron condors.

If the trader is correct and the market price of the underlying asset makes a larger move than was originally forecast by the options chain, the long volatility arbitrage strategy has succeeded, and the long options will increase in value.

A short volatility strategy works just the opposite. Traders look at the options chain in question and decide that the options are overpriced — meaning the options chain forecasts a larger move than the trader thinks the underlying asset will make. To take advantage of this discrepancy, a volatility arbitrating trader may look to sell volatility. Common short volatility option strategies include short iron condors, short iron butterflies, and even calendar spreads (though these often have a slight directional lean).

How to Identify Volatility Arbitrage Strategy Opportunities: Earnings and Catalysts

Stock market earnings can be a treacherous period for options traders due to the high implied volatility that often comes along with it. It isn’t just earnings that can make a big splash. Market-moving events like the CPI, the FOMC, and key economic data can all drive price action, and they too often come paired with high IV.

High IV means options have a higher market price (driven by rising extrinsic value). However, sometimes even the most sky-high implied volatility isn’t high enough to keep up with the colossal price action of these stocks. It’s up to the trader to uncover the opportunity in volatility.

You don’t have to use this strategy around a specific catalyst. Plenty of volatility hunters prefer to trade this strategy during non-event periods. This prevents unplanned market moves from throwing a wrench into the trade. However, whether you’re trading an event like earnings or not, the one commonality is that volatility arbitrage requires a discrepancy between the price of options and the stock move that follows.

That’s why the most important skill for any options trader to master is accurately measuring volatility. Options strategies come in all shapes and sizes, and are suited for avwide variety of volatility environments.

For instance, a strangle (made up of an out of the money call option and an out of the money put option) is a long position that is positive Vega (volatility is good) and Delta (dollar moves in your direction are good) — but it comes with heavy time value erosion.

If you thought that volatility was about to swiftly decline, you probably wouldn’t want to use a strangle. Understanding these nuances is paramount to becoming a smarter options trader with a better understanding of the tools before him.

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Measuring Implied Volatility of an Underlying Stock Ahead of Earnings

As you might imagine, measuring the volatility of an asset is a little more complex than just looking at the IV percentage and saying, “is the number big?” That’s because every underlying stock is different. For instance, at the time of writing, near dated at the money Disney (DIS) options carry an IV of 41%. That’s pretty high for Disney. At the same time, the Tesla (TSLA) at the money options expiring on the same date carry an IV of 64% — which is actually quite low for them.

How can you tell if a stock’s volatility is running hot or cold? Here are three ways to judge:

IV Rank

IV rank measures how high the average at the money option volatility is (and subsequently, how expensive the options are) relative to the past 12 months on a scale of 0% to 100%. A 0% rank means that the IV is at its lowest level of the year. A 100% rank means that the options are at their volatility peak for the year.

Generally speaking, higher implied volatility often creates a favorable environment for option sellers, and lower implied volatility often creates a favorable environment for option buyers. But this isn’t the only way that we grade the volatility environment of stocks ahead of earnings.

The VIX

Sometimes volatility is a macro phenomenon. There is no better way to judge market-wide volatility than by looking at the VIX. There are a few different ways to read the VIX. One way you can view the VIX is as a measure of the anticipated daily move of the S&P 500 averaged over the course of the next 30 days. That calculation is easy — divide the VIX by 16 to get the anticipated move in the S&P 500 as a matter of percentage. A VIX of 16 (16/16 = 1) indicates an average daily move of 1% in the S&P 500. VIX of 24? (24/16 = 1.5) That indicates a daily move of 1.5%. VIX of 32? That’s 2%. And on it goes.

You can also judge the VIX against its historic averages. In 2022, the yearly average for the VIX is 26.22. In 2021, it was 19.67. An above-average VIX could be an indicator that stocks are on shaky footing, which could elevate option prices. A below-average VIX means just the opposite — the market isn’t expecting anything big in the near future to rattle things on a macro scale, and as such, option prices may be suppressed.

Both IV rank and the VIX are key measures to monitor when gauging the volatility of an underlying asset. But when trading earnings, there is one more historic measure that must be taken into account.

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Average Earnings Move vs. Implied Move

The implied move measures the size of the move that the at-the-money straddle is pricing in for the specified options expiration. The average earnings move is exactly what it sounds like — a mean average of the previous 1-day moves generated by the underlying stock following the release of an earnings report.

If the implied move is significantly greater than the average earnings move, that could be a sign that the options are overpriced heading into the earnings event. If the implied move is significantly less than the average earnings move, that could be a sign that the options are underpricedheading into the earnings event.

Arbitrating Volatility With Options: The Bottom Line

Whether you’re attempting to use this strategy going into an event like earnings, the CPI, the FOMC, or some other catalyst — or you’re just looking to take advantage of a discrepancy in options pricing, the most important thing you can do is to arm yourself with data. By knowing what is common, we can more easily identify the uncommon.

As a rule, remember that “overpriced” options, high IV rank, high VIX, and big implied moves are traits that lend themselves to premium collection strategies like iron condors. On the other hand, “underpriced” options, low IV rank, low VIX, and low implied moves indicate the opposite — a potential opportunity for a long Vega strategy.

Above all else, always remain calm. Stay disciplined. Have a plan for every trade you make. And let the data (not your emotions) lead the way.

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