Volatility Arbitrage - How does it work? - Options Trading Lessons
Summary
TLDRIn this informative video, Patrick Boyle delves into the world of volatility trading, explaining the Black-Scholes model's role in pricing options and the real-world challenges it faces. He discusses how traders use delta hedging to manage risk and profit from volatility, highlighting the importance of understanding implied versus realized volatility. Boyle also explores the concept of volatility arbitrage, where traders buy low and sell high on volatility based on their forecasts, emphasizing the need for continuous re-hedging to capture profits. The video provides valuable insights for those interested in options trading and financial derivatives.
Takeaways
- 📚 Patrick Boyle introduces the topic of volatility trading and its relation to option pricing, specifically the Black-Scholes model.
- 💡 The Black-Scholes model assumes continuous and riskless delta hedging, which is not feasible in the real world due to trading limitations and market behavior.
- 💼 Real-world trading involves less frequent hedging, and traders often hedge after significant market moves, leading to deviations from the Black-Scholes model's predictions.
- 📉 The underlying assets do not always behave as the Black-Scholes model expects, with trading not being 100% continuous and asset prices experiencing jumps.
- 🌡 Volatility, or the standard deviation of the market, is not stable over the life of the option, which is a key assumption in the Black-Scholes model.
- 💰 Due to the challenges in perfect hedging, options are often sold at a premium to compensate for the risks and costs involved in trading.
- 🔄 Sellers of options are the counterparty with nearly unlimited downside, so they require additional compensation for selling options.
- 🛍 The price of an option is related to the cost of creating it, similar to any other product, and must cover the costs of production, including the risks involved.
- 🔄 Volatility arbitrage involves trading a delta-neutral portfolio to take advantage of differences between implied and forecasted realized volatility.
- 🤔 Volatility traders do not have a directional opinion on the market; they aim to profit from their view on volatility rather than the movement of the underlying asset.
- 📈 The profit in volatility trading comes from the continual rehedges required to maintain a delta-neutral position, which can result in gains if the realized volatility aligns with the trader's forecast.
Q & A
What is the main topic of Patrick Boyle's video?
-The main topic of Patrick Boyle's video is volatility trading, specifically how option traders trade and profit from the volatility of the underlying asset's price on which their option is based.
Why is the Black-Scholes model important in the investment industry?
-The Black-Scholes model is important because it provides a theoretical framework for pricing options. It suggests that if traders could continuously and risklessly delta hedge, the model would perfectly price options.
What are some real-world issues with the Black-Scholes model?
-Some real-world issues include the inability to trade continuously at every microsecond, the fact that underlying assets don't behave as the model assumes (e.g., asset prices jump on news), and that volatility is not stable over the life of the option.
Why do volatility traders and market makers charge a premium above the Black-Scholes price?
-Volatility traders and market makers charge a premium to compensate for the costs and risks associated with imperfect and riskless delta hedging, as well as for the administrative and IT expenses involved in trading options.
What is the relationship between the price of an option and implied volatility?
-The price of an option is closely tied to the implied volatility used in its calculation. Higher implied volatility generally leads to a more expensive option, and vice versa.
What is the role of a volatility arbitrage trader?
-A volatility arbitrage trader attempts to profit from differences between the implied volatility of an option and their forecast of future realized volatility. They aim to buy volatility when they believe it is low and sell when they think it is too high.
How do traders manage the directionality of options through hedging?
-Traders manage the directionality of options by delta hedging. This involves buying or selling the underlying asset to maintain a delta-neutral position, thereby isolating exposure to volatility rather than direction.
What is the significance of gamma in delta hedging?
-Gamma represents the rate of change of delta for a 1% change in the price of the underlying asset. It is crucial in delta hedging because it dictates how often and by how much the trader needs to adjust their position to maintain delta neutrality.
How can a trader realize a profit from a volatility trade?
-A trader can realize a profit if the realized volatility of the underlying asset is closer to their forecast than to the market's forecast (implied volatility). Profits are extracted through the continual rehedges required to maintain a delta-neutral portfolio.
What happens if the underlying asset's volatility is less than the implied volatility?
-If the underlying asset's volatility is less than the implied volatility, the trader who is long volatility (and has bought options) will likely lose money, as they would not make back the premium paid for the options through hedging.
What is the opposite outcome for a trader who is short volatility?
-If a trader is short volatility and the underlying asset's volatility is less than the implied volatility, they would keep the entire premium received from selling the options, as there would be no significant market movements requiring hedging.
How does the concept of 'Delta hedging' relate to the profitability of a volatility trade?
-Delta hedging is directly related to the profitability of a volatility trade. If the market moves less than expected, the trader makes back less of the premium paid. If it moves more, they make more than the premium spent, potentially generating significant profits.
Outlines
📚 Introduction to Volatility Trading and Black-Scholes Model
Patrick Boyle introduces the topic of volatility trading, explaining how option traders capitalize on the volatility of the underlying assets. He mentions that the video is part of a series on dynamic hedging and provides a link to the playlist. Boyle discusses the Black-Scholes model, which theoretically prices options based on the assumption of continuous and riskless Delta hedging. However, he points out the discrepancies between the model and real-world trading, such as the inability to hedge continuously and the unpredictable behavior of asset prices. He also explains that due to these real-world challenges, options are often sold at a premium to compensate for the risks and costs involved in Delta hedging.
🔍 Volatility Arbitrage and Delta-Neutral Trading Strategy
This paragraph delves into the concept of volatility arbitrage, a strategy used by traders to exploit the difference between implied and forecasted realized volatility. Boyle clarifies that this is not a true arbitrage due to the element of forecast involved. Traders aim to profit from their views on volatility without having a directional bias on the market. They look for options where the implied volatility diverges from their forecasts and engage in Delta hedging to maintain a delta-neutral position, which isolates them from directional market movements. The profit or loss from these trades is realized through the continuous adjustment of the Delta position, which can result in gains if the market's realized volatility aligns with the trader's forecast.
📉 Examples of Volatility Trading Outcomes
Boyle provides two examples to illustrate the outcomes of volatility trading. In the first scenario, a trader is long volatility but the market remains stagnant, resulting in a loss of the entire premium paid for the option. Conversely, in the second example, the market experiences extreme volatility, leading to substantial profits from the hedging activities, far exceeding the initial premium spent. These examples underscore the importance of accurate volatility forecasting and the impact of market movements on the profitability of volatility trading strategies. The video concludes with an invitation for viewers to engage with the content, subscribe for more, and consider a recommended book on the subject.
Mindmap
Keywords
💡Volatility Trading
💡Black-Scholes Model
💡Delta Hedging
💡Implied Volatility
💡Realized Volatility
💡Volatility Arbitrage
💡Option Premium
💡Riskless Hedging
💡Underlying Asset
💡Gamma
💡P&L (Profit and Loss)
Highlights
Introduction to volatility trading and its significance in options trading.
Explanation of the Black-Scholes model and its relevance in pricing options.
Discussion on the limitations of the Black-Scholes model in real-world trading.
Real-world traders do not hedge continuously as assumed by the Black-Scholes model.
Volatility traders and market makers charge a premium to sell options to compensate for risks and costs.
Comparison of option selling to selling insurance policies, emphasizing the need for fair compensation.
Explanation of Delta hedging and its role in volatility trading.
Introduction to volatility arbitrage as a type of statistical arbitrage.
Objective of volatility arbitrage: exploiting differences between implied and forecasted volatility.
Traders do not have a directional opinion on the market; they focus on volatility.
Long volatility means buying options and hedging Delta; short volatility means selling options and hedging Delta.
Importance of Delta-neutral positions in volatility trading.
Explanation of Gamma and its impact on Delta-neutral positions.
Example scenarios illustrating profit and loss based on market movements and hedging strategies.
Conclusion on how volatility trading works and its practical applications.
Transcripts
hello my name is Patrick Boyle welcome
back so today we're going to learn about
volatility trading and we're going to
learn about how option traders trade and
how they try and profit from the
volatility of the price of the
underlying that their option is based
upon if all of this is new to you that
this video is part of a longer series
that I'm doing on dynamic hedging and if
you want to watch that whole series I've
put it in a playlist that is linked to
right there so anyhow today we're just
talking about volatility trading and how
that works so firstly we have to look
back at the idea of the black Scholes
model and how we price options and kind
of why the black Scholes model is
actually useful and interesting and why
it matters - to people in the investment
industry so the black Scholes model
tells you that if traders were able to
riskless Lee Delta hedge continuously in
the manner described in in the manner
that we're gonna describe in today's
class that this model would perfectly
price options okay now the problem is
that there are of course some real-world
issues with the black Scholes model so
in the real world traders to not always
hedge continuously right you can't trade
at every microsecond and in fact often
they just do it daily maybe to close a
day or hourly or often they'll just wait
til there's a big move and hedge you
know
so the real world is a little bit
different than the world described by
the black Scholes model equally the
underlying asset doesn't behave exactly
the way it is described in the black
Scholes model trading is not a hundred
percent continuous asset prices jump on
big news or on announcements or even
just when the market is closed overnight
it's reasonable to expect the market to
gap up or down by the
so volatility our standard deviation is
not stable over the life of the option
and that's of course an important part
of the black Scholes model is that idea
and so because of these difficulties
with perfectly and riskless Li Delta
hedging options volatility traders and
market makers usually are going to
charge a small premium to sell options
above what might be the perfect black
Scholes price and this is essentially
that they need to be compensated for the
costs of what they're doing right
because how it often works in the
options world is that there's lots of
people who sort of like the idea of
buying options they like the idea you
know buying a put option in order to
insure their portfolio it's a little bit
like buying an insurance policy on your
house or your car makes people
comfortable
someone has to sell that and you know
when we early on in this video series we
described the payoffs of being long and
short options I imagine lots of people
who are new to this think well gosh you
know I I can understand why you would
buy an option but it seems unreasonably
risky to sell an option and it it sort
of is unless you're over paid for them
right so essentially sellers of options
they don't have to sell options they can
they can do other things with their day
you know they're really going to only
sell options if they feel that they're
being offered enough money to compensate
them for doing the kind of work that
we're about to describe today that
involves Delta hedging that auction and
trying to hopefully you know hedge it
out and end up with a small profit
leftover so our sellers charge this
premium because they're the counterparty
would unlimited our nearly unlimited
downside in the options payoff and so
for that reason they're just not really
going to get involved a little bit like
an insurance company they're not going
to sell you an insurance policy it fair
fair value they're gonna work out the
fair value of you
current policy and charge you a little
bit more in order to make it reasonable
for them to you know to go to all of
this work and the work isn't just the
risk there's kind of there's all the
sort of paperwork and IT expenses
associated with that and that has to be
encapsulated in this price as well so
that leads us to the idea that actually
an option is like almost any other
product that you might buy the price of
it kind of just relates to the cost of
creating it right like when you buy a
pair of shoes
how much does issue cost well it
shouldn't cost less than the leather and
the stitching and the you know the labor
and whatever else that goes into it
otherwise people wouldn't want to make
them and so volatility traders
volatility arbitrators to a certain
extent kind of manufacture options for
people to buy so let's look a little bit
at this idea of volatility arbitrage or
what volatility traders do and see see
how it might make sense for someone to
do this so in finance volatility
arbitrage is a type of statistical
arbitrage that's implemented by trading
a delta-neutral portfolio that I've
explained in earlier videos of an option
and it's under lire
the objective is to take advantage of
differences between the implied
volatility of the option and I have a
video on unemployed volatility if you
need to watch that but their objective
is to take advantage of differences
between the implied volatility of the
option and their forecasts of future
realized volatility of the options under
lire now of course the problem in there
is it's not really an arbitrage you know
earlier when I explained what arbitrage
was this clearly isn't an arbitrage just
because it's their forecast of
volatility and that may or may not be
right you know will
have to find out over time whether that
works in volatility arbitrage traders
attempt to buy volatility when they
believe it to be low and sell volatility
when they think it is too high usually
they don't have a directional opinion on
the market so they're not trading in
order to profit from the price at the
underlying moving up or moving down
they're simply trying to profit based
upon their view on volatility so how
does this work will the trader looks for
options where the implied volatility is
either significantly lower or higher
than their forecasts realized volatility
for the underlined so they're basically
when I say they look for ones where
implied volatilities I essentially that
kind of means options that are too
expensive because as you hopefully know
from our earlier videos the price of an
option is very much tied to the implied
volatility used in the calculation now
because the trader is not trading
directionally they don't care if these
are calls or puts okay so an owl Atilla
tea trader is either they don't want to
be long or short volatility which means
long or short options now they don't
care if their puts are calls because
they're gonna hedge out the
directionality they're just going to be
exposed to this volatility portion of
the option so if you buy options and
help hedge the Delta your long
volatility if you sell options and hedge
the Delta your short volatility so
basically if your long option to your
long volatility if your short options
your short volatility but you also have
that directional component and you're
able to get rid of that directional
component through Delta hedging so over
the holding period our trader will
realize a profit on the trade if the
underlines realized fall is closer to
our traders forecast than it is to the
markets forecast which was the implied
volatility and the profit is extracted
from the trade and this is the important
point the profit is extracted from the
trade through the continual rehashing
required to keep our portfolio Delta
trouble so as you can see up here on the
screen right now we've got our payoff
diagrams of puts and calls and you can
be long or short them and if you're long
a call or long put your long volatility
but then you need to hedge at the Delta
and if you're sure to call or shorter
put you are short volatility but of
course you need to hedge out the Delta
once again as described I'm not on that
slide so how do you extract the value
well once you have a delta-neutral
position and I've kind of explained
Delta and Delta neutral trading in an
earlier video would you have this
delta-neutral position if the market
moves you find that you have to buy and
sell the underlying in order to stay
delta-neutral and that's because of
gamma gamma is the amount the Delta
changes for a 1% change in the price of
the underlying now if this this hedging
is going to generate profits and losses
if the underlying realizes the same
volatility as was implied
then your hedging will cost you the
amount of the premium you received or
generate profits equal to the premium
paid out hopefully that makes sense so
let's look at an example now in this
example I'm using this idea of 16%
implied fall and that's just because
I've reverse engineered that from a 1%
daily swings in the underlying would
equal 16% implied fall so if we bought a
call with 16% implied volatility and
sold the underlying against it to be
delta-neutral if the market never moved
again between initiating this position
our Delta would never change right and
if our Delta doesn't change we find that
we're never hedging now if we're never
hedging we can't generate profits or
losses right so we paid we bought a call
so where long volatility we're expecting
it to move more than 16 percent standard
deviation or
1% today and what we find is that it
doesn't move at all and what that means
is that we lose the entire premium right
because we don't make anything back at
all from our hedging now someone else
who sold us that option will have
received the full premium that we paid
them and the price of the underlying
won't have moved at all and so they will
will never have to rehash and thus they
will have managed to keep the entire
premium so we were in that example long
volatility and wrong about the
volatility we're extremely wrong so
let's look at the opposite of that say
the same example we bought a call 16
percent implied volatility sold the
underlying against it in order to be
dealt a neutral to 0.5 Delta option and
instantly what happens is the price of
the underlying falls straight to zero
right no soon aren't you have you bought
the call and hedged yourself than the
price of the underlying falls to zero
now at 0 the the Delta of this option
will also be 0 right so we were short 50
shares we have to buy all 50 of them
back right because we no longer need to
have that position now we'll imagine
that we do that and instantly the price
rockets and it doesn't rock it a little
bit it goes up like a top you know it
goes to houses we'll say if it started
at a hundred it goes to a thousand so we
recalculate our Delta and what do we
find we find that the Delta now is
around one and so what we have to do we
have to sell 100 shares and so we'll
imagine if this just kept on happening
so we were expecting the underlying to
swing one percent a day and within a
single day we've got these massive
thousands of percents of percentages of
swings right and every time it makes
these big swings it keeps fluctuating
between zero and a thousand and every
time it does that we're either buying or
selling the underlying and this is of
course generating us huge profits right
where we're hedging our options about
that we're not really
you know losing money on the option
because we keep rehashing but not only
that we're making huge profits from the
hedging and this is because the price is
moving way more than expected so in our
last example it moved way less than its
expected in fact it didn't move at all
and we lost all of the money that we
made in premium and in this example it
moved way way way more than was expected
and we're making way way way more back
than we spent on premium to begin with
so hopefully you understand with this
example how volatility trading works so
essentially if it swung around about 1
percent a day and we diligently rehash
their Delta us as described in my
earlier video on Delta hedging you would
find that you make back the amount of
money that you spend in options premium
but when it moves less you make back
less and when it moves more you make
much more than you spent in options
premium so that's really what it means
to be long volatility and then obviously
the person at the other side of each of
those trades will say with short
volatility and they'll have really the
exact opposite PNL assuming that they
don't sorta hedge identically or if they
do hedge identically to us they'll have
the exact opposite P&L to us so in the
first example they'll they'll have kept
the entire premium and in the second
example they'll have lost a ferocious
amount of money because of these large
swings so hopefully that video was
helpful if you'd like if you liked it
and you must have to watch almost 30
minutes of it please hit the like button
if you want to see more like this hit
the subscribe button and if you're
interested in the book that all of this
is based on it's called trading and
pricing financial derivatives
derivatives and it's linked to in the
description below so have a great day
and tune in again for more of these
videos and do comment below if you've
any questions about this talk to you
later bye
Ver Más Videos Relacionados
Understanding Market Makers || Optiver Realized Volatility Kaggle Challenge
US-Wahl 2024 - Effektive Hedging-Strategien für Optionshändler
The Barclays Trading Strategy that Outperforms the Market
Why ATR is the ONLY thing I put on my charts
News will tell you When to Trade (Economic Roadmap) - Ep 25
Unusual Whales Gamma Exposure Dashboard: The Basics of GEX and Market Maker Volatility Suppression
5.0 / 5 (0 votes)