Check out the top 4 stocks to watch in October 2022
tastytrade logo
uploaded image

Apr 16, 2019

Fresh Insights on Retail "Vol Arb"

By:Sage Anderson

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:

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:

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.

Related Posts

tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on 

tastytrade is a trademark/servicemark owned by tastytrade.

tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).

tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.

Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.

© copyright 2013 – 2022 tastytrade. All Rights Reserved. Applicable portions of the Terms of use on apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastytrade’s podcasts as necessary to view for personal use.