Volatility arbitrage is a simple yet powerful option trading model. Imagine you are an option buyer and you had bought the 11050 Call @ Rs. 40, when the market was around 10800. Thereafter, the market moved up to 11100 in the next two days and you sold the 11050 call at Rs.90. You made a profit despite 2 days of time decay because the drift in volatility was evenly spread in one direction. Now imagine a scenario where you had bought the 11050 call when the market was at 10800. This time, the market did not show a one sided up-move, rather it moved up, fell down 300 points and finally closed at 11100. The uneven distribution in market volatility caused your option to lose its premium and this is where most option traders are confused. So what is the possible solution?
Notice, in the 2nd case the 11050 call premium failed to expand, however, in the 1st case the 11050 call premium doubled despite the time decay. It was the uneven shift in market volatility that caused the option premium to decay in the 2nd case. Most hedge funds use Terminal Volatility to deal with such situations. Terminal volatility provides them with a lethal edge. Volatility Arbitrage is one such tool designed to profit from options even if you have no knowledge about market direction or trend.
Finding The Edge
We all know that option premiums are heavily dominated by market volatility. But when you trade options you’ll notice, not all strikes on the option chain undergo the same change in premium due to the drift in the underlying volatility of the market.
What does this actually mean? Simply put, during some weeks Nifty and Bank options display a parabolic volatility curve also known as a smile. When this happens the OTM options gamma expands exponentially versus the ATM strike. That is when we go for the kill.
Now go back to the Nifty 23rd July weekly contract, on the Monday the 20th of July at 1:40 pm. The volatility arbitrage opportunity occurred. A sudden exponential expansion in 11200 call and 10750 put was triggered. Thus we sold 2 lots of 10750 put @ 36 and 2 lots of 11200 call @ 23, at the same time, we bought 1 lot of the 11050 call option @ 63,. A long credit spread was created at Rs.(-53). In a long credit spread, the buyer receives an initial cash flow for initiating the position. The combined spread was carried overnight till Wednesday and was booked at a net profit of Rs.102. Today when Nifty future closed at 11215, the same spread bagged a net profit of Rs.190. You must keep in mind that the spread has generated a massive return, despite Nifty closing above 11200 today. This yet again proves that the exponential expansion in the 11200 OTM call and 10750 OTM put captured by the system on Monday was absolutely spot on.