Volatility Trading

Understanding implied volatility and volatility skew trading strategies

Learning Objectives

Understand implied volatility vs realized volatility

Analyze volatility skew and term structure

Implement volatility arbitrage strategies

Use VIX and volatility ETFs effectively

Volatility Fundamentals

The foundation of volatility trading

Implied vs Realized Volatility

Implied Volatility (IV)

Market's expectation of future volatility based on option prices. Forward-looking measure.

Realized Volatility (RV)

Actual price movement of underlying. Historical measure calculated from price changes.

Volatility Mean Reversion

Volatility tends to revert to its long-term average. High IV periods often followed by lower IV, and vice versa.

Key Insight:

When IV > RV consistently, selling volatility (selling options) may be profitable. When IV < RV, buying volatility (buying options) may be advantageous.

Volatility Skew and Smile

Understanding non-uniform volatility across strikes

Put Skew

In equity markets, OTM puts typically have higher IV than ATM options due to crash protection demand.

Term Structure

How IV varies across different expiration dates. Often shows contango (longer-term >shorter-term) or backwardation.

Trading Skew

Sell rich puts, buy cheap calls (put spread)

Calendar spreads to capture term structure edges

Ratio spreads to exploit skew anomalies

VIX and Volatility Products

Trading volatility through specialized instruments

VIX Characteristics

• Measures SPX 30-day implied volatility
• Mean-reverting: spikes during fear, declines during calm
• Cannot be traded directly (index, not tradeable security)
• VIX futures and options available for trading

Volatility ETFs

Long Vol ETFs

VXX, UVXY - bet on rising volatility

Short Vol ETFs

XIV (discontinued), SVXY - bet on falling volatility

Critical Warning:

Volatility products suffer from contango decay. They're not buy-and-hold investments. Use only for short-term trades with defined risk management.

Advanced Volatility Strategies

Straddle/Strangle Management

Advanced techniques for managing long volatility positions:

Delta hedging to isolate volatility exposure

Gamma scalping for realized volatility profits

Volatility surface arbitrage opportunities

Event-Driven Volatility

Trading volatility around known events:

• Earnings announcements
• FDA approvals (biotech)
• FOMC meetings
• Economic data releases
• Merger arbitrage situations

Portfolio Volatility Hedging

Using volatility products to hedge portfolio-wide risks during market stress periods.

Volatility Trading Risks

• Volatility can remain irrational longer than you can remain solvent

• Contango decay in volatility products can be severe

• Liquidity can disappear during volatility spikes

• Model risk: volatility models can break down in extreme markets

• Correlation risk: volatility often spikes when correlations converge to 1