One niche trading style in the hedge fund world is volatility arbitrage, commonly referred to as "vol arb."

This approach basically entails buying and selling volatility in a balanced manner, and preferably in underlying symbols that share a strong correlation.

For example, a vol arb energy trader might buy premium in XOM versus selling premium in CVX, with the goal that implied volatility in both will revert to the mean, and produce a positive return on capital. Obviously, a critical element to the strategy is the ability to consistently and correctly evaluate whether implied volatility is "cheap" and "expensive."

One big risk to this approach, especially when dealing in single stocks, is that the short premium position experiences a "big move" in the underlying stock, while the long premium leg of the trade fails to follow suit.

Another headwind for volatility arbitrage is the existence of time decay, which can cancel out the potential benefit of long volatility, as well. On the tastytrade network, this obstacle has been illustrated quite clearly through extensive backtests. Based on empirical evidence, long premium positions rarely produce attractive win rates in the long run - even when implied volatility is "cheap" (i.e. IV Rank < 50%).

In order to provide further illumination on this topic, the Market Measures team recently conducted an analysis on the pros and cons of volatility arbitrage for retail traders. Due to the increased risk presented by single stock options, the team instead focused on index options, which are more diverse and therefore less susceptible to "catastrophic moves."

Theoretically, a portfolio comprised of balanced long and short volatility positions is less exposed to directional risk (assuming it's hedged delta neutral), and also reduced volatility in the P/L. The latter point assumes there are no out-sized positions, and that the portfolio is constructed with similar-sized exposures.

On Market Measures, a study is presented which analyzed the historical success of a volatility arbitrage strategy deployed in SPY and DIA. These two underlying symbols were selected because SPY traditionally trades with higher implied volatility than DIA (on average).

Additionally, the two symbols historically share a strong, positive correlation. The implied volatility and correlation data describing the relationship between SPY and DIA are highlighted in the graphic below:

Vol Arbitrage

The next step in this analysis involved a backtest, conducted on data from 2005 to present, which assessed the performance of a portfolio comprised of a short strangle in SPY alongside a long strangle in DIA. The strangles in both symbols were 16-delta with 45 days-to-expiration (DTE), and were all held through expiration.

Essentially, this exercise measured the historical performance of a two-position volatility arbitrage portfolio. For comparison purposes, a portfolio comprised of only short strangles in SPY was also backtested and included in the results, which are summarized in the slide below:

Vol Arbitrage

There's a lot to unpack in the above data, despite the fact that the study involved only two different underlying symbols.

First, we can see that both approaches - volatility arbitrage using SPY and DIA, as well as the stand-alone SPY approach, produced a positive P/L (on average). It should be noted, of course, that the "vol arb" approach produced the lower average P/L when compared to the simple short strangle approach in SPY.

What's equally interesting are some of the risk assessments that can be made from the above data. Earlier in this post we asserted that the "vol arb" approach would theoretically exhibit less directional risk, as well as less volatility in daily P/L.

Both of these expectations were confirmed in this backtest, as we observed a smaller "largest loss" and a reduced standard deviation in P/L. The fact that the vol arb approach involves two legs to the trade, as opposed to only one in the SPY stand-alone approach, did translate to a slightly higher buying power reduction (BPR).

Depending on your own trading style, outlook, and risk profile, the results of this study may provide food for thought going forward. Traders seeking to reduce risk and volatility in their P/L may decide to give "volatility arbitrage" a closer look.

If you want to learn more about volatility arbitrage for retail traders, we recommend reviewing the complete episode of Market Measures when your schedule allows.

Additionally, traders can always mock trade a "volatility pair" (i.e. long and short volatility positions) in order to better understand how such positions behave and perform. This is a great way to gain experience with new products and strategies without the risk of capital losses.

If you have any questions about the topics explored in this post, don't hesitate to reach out by leaving a message in the space below, or dropping us a line @tastytrade (Twitter) or (email).

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.