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
Famous quotes containing the word mechanism:
“Life is an offensive, directed against the repetitious mechanism of the Universe.”
—Alfred North Whitehead (1861–1947)
“The two elements the traveler first captures in the big city are extrahuman architecture and furious rhythm. Geometry and anguish. At first glance, the rhythm may be confused with gaiety, but when you look more closely at the mechanism of social life and the painful slavery of both men and machines, you see that it is nothing but a kind of typical, empty anguish that makes even crime and gangs forgivable means of escape.”
—Federico García Lorca (1898–1936)
“When one of us dies of cancer, loses her mind, or commits suicide, we must not blame her for her inability to survive an ongoing political mechanism bent on the destruction of that human being. Sanity remains defined simply by the ability to cope with insane conditions.”
—Ana Castillo (b. 1953)