Volatility Arbitrage - Forecast Volatility

Forecast Volatility

To engage in volatility arbitrage, a trader must first forecast the underlier's future realized volatility. This is typically done by computing the historical daily returns for the underlier for a given past sample such as 252 days (the typical number of trading days in a year for the US stock market). The trader may also use other factors, such as whether the period was unusually volatile, or if there are going to be unusual events in the near future, to adjust his forecast. For instance, if the current 252-day volatility for the returns on a stock is computed to be 15%, but it is known that an important patent dispute will likely be settled in the next year and will affect the stock, the trader may decide that the appropriate forecast volatility for the stock is 18%.