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Caesaria
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Joined: November 25th, 2010, 2:54 pm

what is volatility arbitrage?

December 2nd, 2011, 3:30 pm

Can greater profits be realized by delta hedging in non equally spaced intervals? In other words, if you are long vol through buying some options, could you realize greater profits if you were to delta hedge at unequal intervals? Is that the foundation of volatility arbitrage hedge funds? Rather than trying to realize volatility from settle to settle, do they try to realize to realize greater volatility from unequal discrete points based on some backtesting of these intervals?
 
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BramJ
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Joined: January 10th, 2006, 2:01 pm

what is volatility arbitrage?

December 3rd, 2011, 1:44 am

QuoteOriginally posted by: CaesariaCan greater profits be realized by delta hedging in non equally spaced intervals? In other words, if you are long vol through buying some options, could you realize greater profits if you were to delta hedge at unequal intervals? Is that the foundation of volatility arbitrage hedge funds? Rather than trying to realize volatility from settle to settle, do they try to realize to realize greater volatility from unequal discrete points based on some backtesting of these intervals?As far as I understand, no. Disciplined, smart delta-hedging is needed to capture an edge (which you predict on the basis of some model you have for volatility; PWOQF part 3 contains an example I think), but it's not the source of the edge. Try google for ways of delta-hedging. Zakamouline for example has a paper where he proposes to rehedge when your delta moves out of a certain bandwith where the bandwith is a function of (by heart) time to maturity, volatility of the underlying and your risk tolerance.
 
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undergrad86
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what is volatility arbitrage?

December 4th, 2011, 9:51 pm

Volatility arbitrage is by its nature profiting from mis-priced volatility. The delta hedging makes absolutely no contribution to the edge, its sole purpose is to hedge the exposure to the underlying. A volatility arbitrageur has no view on the direction of the underlying. Therefore delta hedging no matter how its done cannot change the edge of the strategy, it can only affect its risk characteristics.There are two exceptions to this. First would be the effect of transaction costs on the strategy. The more frequently you delta hedge, the lower your strategy volatility, but the more you pay in transaction costs trading the underlying. A smart trader knows when and how to make this tradeoff. The second is if you're running some sort of short term strategy as an overlay to your vol arb strategy. Say you have a strategy trading the underlying that produces positive edge before transaction costs, but isn't profitable after. It can still enhance your vol arb returns when run as an overlay because it can be used to time your delta hedges.
 
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sof
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what is volatility arbitrage?

December 5th, 2011, 6:59 am

Sometimes what is being referred to as "Vol Arb" is actually not an arbitrage in the sense that it is not a riskless profit. Most entities doing volatility arbitrage use systematic ways of trading volatility with the help of signals relying on statistical methods. So it is actually closer to "Statistical Arbitrage" than pure arbitrage per se. I believe most strategies in this field are based on spread / dispersion positions to take advantage of reversals in volatility levels.
 
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mg298
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Joined: September 13th, 2007, 8:11 am

what is volatility arbitrage?

December 5th, 2011, 9:43 am

"Can greater profits be realized by delta hedging in non equally spaced intervals?"yes, if you can do it better than the majority of other market participants - this is not trivial though. Loosely speaking they are likely to increase their realized vol (on equities at least) by hedging more frequently than daily, due to the (slightly) mean reverting nature of equity prices. If you have lots of options to hedge, what you describe might require automating, which costs £$£ to setup and might not be worthwhile unless the hedging improvement is sufficient. Where I worked, our reference was daily hedging, rather than just sitting on the options until expiry."Is that the foundation of volatility arbitrage hedge funds?"no, this is not the foundation, but may be a tool used to give them an advantage on some of their trades. The foundation is deciding what volatility to trade...They fundamentally want to trade Implied and/or realized vol across individual or baskets of underlyings. E.g. if you believe realized>implied for AMD over the next 6Months, you might buy some 6M options/varswaps and hedge them, on average picking up a bit more realized vol using your "non-equally spaced intervals", but this is unlikely to turn a bad volatility bet into a good one. For a non-realised vol example, you might also believe the 3M implied vol in 3 months time will be different to what the market currently has priced... so you might trade a forward volatility agreement, purely based on your belief about 3M implied vol in three months time, with the intention of liquidating your position in 3Months time, and (hopefully) profiting from the move in implied vol.Some funds will be predominately short vol and so not want to hedge often in the way you describe even if they could.
Last edited by mg298 on December 4th, 2011, 11:00 pm, edited 1 time in total.