Volatility Arbitrage: The Basics of
I remember being very intimidated when I first heard about Volatility Arbitrage. I learned that it was just a fancy way of saying what many options traders do for a living.
So what is volatility arbitrage? Volatility arbitrage is a statistical way to trade options. The law of big numbers. If you enter trades with high probability of 70 % and you will enter 1000 trades than around 700 trades will be successful. Learn how to enter high Probalitiy Of Profit trades. Out of the money options tend to loose their premium. And at expiration these option are worth nothing anymore.
Due to moving prices in the underlying, political news, expectations of the traders and earning announcement Implied Volatility fluctuates very much. The moment high Implied Volatility rises very much, let say above 50, you know that it does not stay long. It has to reverse to the mean. This knowledge gives you an advantage to sell options with high Implied Volatility.
Volatility arbitrage takes advantage of high and low volatility of options. In the conventional way traders use it only in conjunction with delta neutral strategies. We use it with all kind of high Implied Volatility strategies. Instead of a direction play you are betting on the volatility of the particular option decreasing.
Example of Volatility Arbitrage
Looking at the my watch list I notice that Oracle is down. In Tastyworks I quickly typed in the symbol ORCL. I discovered that Implied Volatility is 56% And when it is above 50% I know that selling an option and receiving premium works the best. When I am looking at the graph I see that ORCL is near an high. I decide to sell an call two strikes above the market price. The options has 32 delta, that means that we have a probability of 68% to keep the credit received. So, I sell the option with 45 days to expiration. The stock may go down, stay flat or go up a little bit and I still can make some money. If it goes up the volatility will drop.
We manage my positions early. As soon as a trader can take 50% of the profit he/she will close the position. Better to have a winning position in my pocket than wait to long and see the profit melting away. If you are a small you might consider selling a call spread instead of a naked call. By doing so you have defined trade risk, and you have to reserve less capital to make this trade.