Thursday, April 8, 2010

Implied/Realized volatility arbitrage

Pretty good article of exploiting index volatility discrepancies for a statistically expected profit.

Key Concepts
Volatility arbitrage is morphing from a niche institutional
strategy to mass market, index-linked products.

Volatility arbitrage strategies attempt to take advantage of the
difference between the implied volatility of an asset and its
realized volatility.

Variance swaps are ideally suited to capturing the difference
between implied and realized volatility.

Volatility arbitrage indices, such as the S&P 500 Volatility
Arbitrage Index, measure the performance of a tradable short
variance swap strategy that is long implied volatility and short
realized volatility.

Since 1990, the S&P 500 Volatility Arbitrage Index has
outperformed the S&P 500 at an annualized rate of more than
three percentage points while having one-third of benchmark
volatility. It has never had a twelve-month negative return period.

It's pretty clear that profit potential off this strategy lies in a deep understanding of the math involved (e.g. GARCH, cointegration, ARIMA, and etc.)

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