Mechanism
Armed with a forecast volatility, and capable of measuring an option's market price in terms of implied volatility, the trader is ready to begin a volatility arbitrage trade. A trader looks for options where the implied volatility, is either significantly lower than or higher than the forecast realized volatility, for the underlier. In the first case, the trader buys the option and hedges with the underlier to make a delta neutral portfolio. In the second case, the trader sells the option and then hedges the position.
Over the holding period, the trader will realize a profit on the trade if the underlier's realized volatility is closer to his forecast than it is to the market's forecast (i.e. the implied volatility). The profit is extracted from the trade through the continuous re-hedging required to keep the portfolio delta-neutral.
Read more about this topic: Volatility Arbitrage
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