Volatility arbitrage, also known as volatility trading or vol arb, is a trading strategy that involves taking advantage of discrepancies in the implied volatility of financial instruments. Implied volatility is a measure of the expected volatility of an asset's price, as implied by the prices of options on that asset.
In volatility arbitrage, traders look for discrepancies between the implied volatility of an asset and its actual, realized volatility. For example, if the implied volatility of an asset is higher than its realized volatility, the trader might sell options on the asset, betting that the asset's price will not be as volatile as the options market suggests. Conversely, if the implied volatility is lower than the realized volatility, the trader might buy options on the asset, betting that the asset's price will be more volatile than the options market suggests.
There are several different approaches to volatility arbitrage, including relative value, statistical, and risk arbitrage. Volatility arbitrage can be a complex and sophisticated trading strategy, and it can involve significant risks, particularly if the trader is unable to accurately predict changes in an asset's implied or realized volatility. As with any trading strategy, it is important to thoroughly understand the risks and limitations of volatility arbitrage before entering into any trades.