From Option Theory to Trading Strategy #4

Volatility Arbitrage in the Black-Scholes World

Junsu Park ™

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 1 / 18

Table of Contents

1 Problem Statement

2 P&L Dynamics
Hedging the True Delta
Hedging the Market Delta
Simulation

3 Strategy Specification
Strike Selection
Expiry Selection

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 2 / 18

Volatility Arbitrage Problem

Assume that all the Black-Scholes assumptions hold, except for the
no-arbitrage condition.

The market is pricing options using an incorrect volatility σI and does

not change its opinion.

By using a volatility estimation method, we determine that the true

volatility is σR . Without loss of generality, assume σR > σI .

We aim to exploit this arbitrage opportunity for profit.

Remark
σI is called implied volatility and σR is called realized volatility.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 3 / 18

Table of Contents

1 Problem Statement

2 P&L Dynamics
Hedging the True Delta
Hedging the Market Delta
Simulation

3 Strategy Specification
Strike Selection
Expiry Selection

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 4 / 18

P&L Dynamics
(I) (R)
Let Vt be the market price of an option and Vt be the fair price of the
option priced using σR . Now, consider a self-financing portfolio, Π, where
Π0 = 0,
Long one option with strike K,
Short ∆t futures contracts.
(I) (I)
dΠt =dVt − ∆t dFt + r(Πt − Vt )dt
! !
(I) (I) (I)
∂ Vt 1 ∂ 2 Vt 2 2 (I) ∂ Vt
= + F σ + r(Πt − Vt ) dt + − ∆t dFt
∂t 2 ∂ Ft2 t R ∂ Ft
! !
(I) (I)
1 ∂ 2 Vt ∂ V t
= F 2 (σ 2 − σI2 ) + rΠt dt + − ∆t dFt
2 ∂ Ft2 t R ∂ Ft

(I) 2 (I)
∂ Vt (I)
The third equality holds since ∂t = − 12 ∂∂ VFt2 Ft2 σI2 + rVt .
t

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 5 / 18

 (R)
∂ Vt
Hedging the True Delta ∆t = ∂F
(R)
∂ Vt
Suppose ∆t = ∂F . Then,
(R)
(I) ∂ Vt
(I)
dΠt = dVt + r(Πt − Vt )dt − dFt
∂F
(I) (I) (R) (R)
= dVt + r(Πt − Vt + Vt )dt − dVt .
The second equality holds because:
 (R) (R)
∂ Vt 1 ∂ 2 Vt 2 2 (R)
+ 2 ∂ F 2 Ft σR − rVt =0 Black Scholes PDE,

 ∂t

 
(R) (R) (R)
(R) ∂ Vt ∂ Vt 1 ∂ 2 Vt 2 2 Itô’s Lemma.

dVt = ∂ F dFt +

∂ t + 2 ∂ F 2 Ft σR dt

Solving the SDE, we get:

   
(I) (R) (I) (R)
d Πt − Vt + Vt = r Πt − Vt + Vt dt
 
(I) (R) (R) (I)
⇒ Πt − Vt + Vt = ert V0 − V0 .

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 6 / 18

 (R)
∂ Vt
Hedging the True Delta ∆t = ∂F

The value of the portfolio (P&L) at time t is given by

 
(R) (I) (R) (I)
Π (t, K, ∆true ) = ert V0 − V0 − Vt + Vt .

The difference between the market price and the fair price is not constant,
and the mark-to-market P&L before the expiry time could be negative.

However, P&L at the expiry time is deterministic.

 
(R) (I) (R) (I)
Π (T, K, ∆true ) = erT V0 − V0 ∵ VT = VT = Ψ(ST ).

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 7 / 18

 (I)
∂ Vt
Hedging the Market Delta ∆t = ∂F

(I)
∂ Vt
If ∆t = ∂F , the instantaneous P&L does not have randomness (dFt ):
!
(I)
1 ∂ 2 Vt
dΠt = F 2 (σ 2 − σI2 ) + rΠt dt.
2 ∂ F2 t R

This implies that the daily mark-to-market P&L of this portfolio is always
positive and predictable. However, the P&L at the expiry time is stochastic
because the cash gamma depends on the path of Ft :
!
(I)
1 ∂ 2 Vt
Z T
2 2 2
Π (T, K, ∆market ) = F (σ − σI ) + rΠt dt
0 2 ∂ Ft2 t R
.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 8 / 18

 (I)
∂ Vt
Hedging the Market Delta ∆t = ∂ Ft

Assuming Ft is driftless under the physical measure P, the expectation of

ΠT is calculated as follows:

σR2 − σI2
Z T
EP [Π (T, K, ∆market ) |F0 ] = erT $Γ (F0 , K, Σt , T) dt
2 0
√ − 18 σ 2 T
where $Γ F, K, σ 2 , T = e−rT FKφσ(z)e log(K/F)


√
T
, z= √
σ T
, and
σR2 t+σI2 (T−t)
Σt = T .

See [2] for the derivation of expectation and variance of Π (T, K, ∆market )
for interested readers.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 9 / 18

Mark-to-Market P&L

# Hedge 1 month (21 days ) call option

F_0 , K , r = 100 , 101 , 0
num_of_hedges , T = 1000 , 1 / 12
sigma_R , sigma_I = 0.2 , 0.15
dt = T / num_of_hedges

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 10 / 18

P&L at the Expiry Time

Due to discontinuous Delta-hedging, the P&L at the expiry time does not
exactly align with the theory but is still close.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 11 / 18

Table of Contents

1 Problem Statement

2 P&L Dynamics
Hedging the True Delta
Hedging the Market Delta
Simulation

3 Strategy Specification
Strike Selection
Expiry Selection

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 12 / 18

Optimal Strategy

Suppose you can only trade 1 lot of an option with strike K and time
to expiry T at the strategy’s inception.

The objective is to maximize the expected annualized profit.

The decision variables you can optimize are K and T.

Practical Consideration
In reality, you may not want to treat holding 1 lot of options with different
expiries or strikes identically. This could impact the optimal strategy.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 13 / 18

Strike Selection

(1) When hedging the true Delta,

 
σR σI T n
(R) (I)
o
F0 exp = argmax V0 − V0
2 K>0

(2) When hedging the market Delta,

 2 
s T n o
F0 exp = argmax EP [Π (T, K, ∆market ) |F0 ]
2 K>0

for some s ∈ (σI , σR ).

The true Delta case can be easily proven by solving the first-order
condition.
They satisfy d1 = 0 for some volatility between (σI , σR ).
Practically, these strikes are not far from F0 .

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 14 / 18

Expiry Selection

(1) When hedging the true Delta, annualized P&L until the expiry time
increases as T → 0 because
√
√

Φ σR −σ T − Φ σI −σ


Π T, Koptimal , ∆true 2
I
2
R
T
= F0 .
T T
(2) When hedging the market Delta, annualized expected P&L until the
expiry time increases as T → 0 because


EP Π T, Koptimal , ∆market |F0 σ 2 − σI2 T F0 φ (d1 )
Z
= R √ dt
T 2T 0 Σt T
 2 2√ 
σ −σ
φ R2σI I T 1 T φ (d1 )
Z
1
√ ≤ √ dt ≤ √ .
σR T T 0 Σt T σI 2πT
Therefore, trading the shortest expiry is optimal.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 15 / 18

Can I use this analysis in practice?

Yes and no.

You can gain insights into designing a volatility arbitrage strategy.

Market practitioners often trade ATM options to express views on
volatility.

If your estimation or prediction of realized volatility is accurate, trading

short-dated options allows you to capture P&L quickly.

The assumptions are unrealistic.

Realized volatility will change over time, and the Black-Scholes model
may give you incorrect Delta.

The market will change its opinion over time.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 16 / 18

Reference

[1] Paul Wilmott. Paul Wilmott on quantitative finance. John Wiley &
Sons, 2013.
[2] Riaz Ahmad and Paul Wilmott. “Which free lunch would you like
today, sir?: Delta hedging, volatility arbitrage and optimal portfolios”.
In: Wilmott 2005.November (2005), pp. 64–79.

Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 17 / 18

Disclaimer

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Junsu Park ™ Volatility Arbitrage in the BS World June 22, 2024 18 / 18