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Volatility Arbitrage

There is a broad  misconception that options have a “cost”.  This perception is derived from the fact that put buyers are “buying downside protection” while call buyers are purchasing upside rights without downside risk.  The thought is that if you are buying protection, then it costs much like car or house insurance costs.  In many cases, this can be true because there is a risk premium built into option prices.  That risk premium is simply the difference between what implied volatilities are priced into options  and what realized volatility turns out to be.  The difference between the implied volatility and the realized volatility of the option is its cost.  The problem with saying it is a *cost* is the fact that realized volatility can most definitely end up being higher than the implied volatility of the option.  You can read more about this in Volatility Selling Strategies.

The bottom line is that an option should be sold or purchased simply based upon your perception of the relative value embedded in the implied volatility assumption.  If the implied volatility seems low relative to your future expectations, then you should be an option buyer.  If implied volatility seems high relative to future expectations, you should be an option seller.  There are many traders who consider themselves exclusively volatility sellers and they primarily sell spreads, condors etc.  I can tell you that they are missing half of the show…

This conversation flows naturally the previous thoughts on gamma trading, so we will expand upon capturing positive or negative implied volatility premiums in a future example.


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