# Volatility Arbitrage > Volatility arbitrage trades the gap between implied volatility and a forecast of realised volatility with delta hedged options. Learn how it works and its risks. Source: https://learn.tradelabsai.com/volatility/volatility-arbitrage/ Track: Volatility · Level: Advanced · Updated: 2026-10-03 Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice. Cite as: TradeLabs Learn, "Volatility Arbitrage", https://learn.tradelabsai.com/volatility/volatility-arbitrage/ Volatility arbitrage is a strategy that buys options whose implied volatility looks too low, or sells options whose implied volatility looks too high, compared with a forecast of the volatility that will actually occur. The options are delta hedged, so that profit comes from the difference between implied and realised volatility rather than from direction. Despite the name, it is not riskless arbitrage: it depends on forecasts that can be wrong and on hedging that is imperfect. ## The core idea When you buy an option and delta hedge it continuously, your profit is approximately: ``` P&L ≈ ½ × Σ gamma × S² × (σ²_realised - σ²_implied) × Δt ``` In words: you earn the difference between realised and implied variance, weighted by the option's dollar gamma over its life. Long options profit if realised exceeds implied; short options profit if implied exceeds realised. See [Gamma Scalping](https://learn.tradelabsai.com/options/gamma-scalping/) and [Delta Hedging](https://learn.tradelabsai.com/options/delta-hedging/). ## The steps 1. **Forecast volatility** for the option's life. 2. **Compare with implied volatility** across strikes and expiries. 3. **Trade the gap:** buy options where implied is below your forecast, sell where it is above. 4. **Delta hedge** regularly. 5. **Close or roll** as the gap closes or expiry nears. ## Forecasting volatility | Method | Idea | Lesson | |---|---|---| | Historical windows | Recent realised volatility predicts near term volatility | [Historical and Realized Volatility](https://learn.tradelabsai.com/volatility/historical-volatility/) | | GARCH models | Volatility clusters and reverts to a long run mean | [GARCH](https://learn.tradelabsai.com/math/garch/) | | Realised volatility models (e.g. HAR) | Combine daily, weekly and monthly realised volatility | | | Implied volatility itself | Implied contains information beyond history | [Implied Volatility (IV)](https://learn.tradelabsai.com/volatility/implied-volatility/) | | Event adjustments | Add expected variance for earnings and announcements | [Earnings Trading](https://learn.tradelabsai.com/strategies/earnings-trading/) | Research generally finds implied volatility is a useful but upwardly biased forecast of realised volatility for equity indices, because of the volatility risk premium. **Example: A volatility arbitrage trade** A stock's 3 month implied volatility is 22%. A trader's forecast, combining a GARCH model with no major events in the window, is 30%. The trader buys at the money options with total vega of $5,000 per volatility point and delta hedges daily. If realised volatility does come in near 30%, hedging gains exceed time decay, and the position also gains if implied volatility rises toward the forecast. If realised volatility comes in at 20%, the trade loses: time decay outweighs hedging gains. ## Sources of mispricing - **Supply and demand imbalances:** heavy option buying for hedging or speculation inflates implied volatility; structured product issuance and overwriting can depress it. - **Slow adjustment** after regime changes. - **Event mispricing:** the market over or underestimates the size of an announcement. - **Relative mispricing** between related underlyings or between options and variance swaps. ## Why it is not true arbitrage - **Forecast error:** realised volatility can differ greatly from any forecast. - **Path dependence:** profit depends on when moves happen. A big move when gamma is small (far from the strike or far from expiry) contributes little. - **Discrete hedging:** hedging daily rather than continuously adds noise. - **Costs:** spreads and commissions on options and hedges. - **Jumps:** sudden gaps can overwhelm hedges. - **Implied volatility moves** create mark to market gains and losses before expiry. ## Variance swaps as cleaner tools Because option based volatility arbitrage depends on gamma along the path, many professionals prefer variance swaps, whose payoff depends directly on realised variance regardless of where the price moves. See [Variance and Volatility Swaps](https://learn.tradelabsai.com/volatility/variance-and-volatility-swaps/). ## Who does it Volatility arbitrage is practised by hedge funds, bank trading desks and options market makers, who have the forecasting models, low costs and infrastructure needed to hedge efficiently. Individual traders can apply the principles, but costs and hedging discipline are major challenges. See [Volatility Trading](https://learn.tradelabsai.com/volatility/volatility-trading/). ## Frequently asked questions ### What is volatility arbitrage? A strategy that trades delta hedged options when implied volatility differs from a forecast of realised volatility, aiming to profit from the gap. ### Is volatility arbitrage risk free? No. It depends on volatility forecasts, which can be wrong, and on hedging that is never perfect. ### How do traders forecast volatility? With historical realised volatility, GARCH and similar models, information from implied volatility itself and adjustments for known events. Next, learn the cleanest volatility instruments in [Variance and Volatility Swaps](https://learn.tradelabsai.com/volatility/variance-and-volatility-swaps/). ## Continue learning - Next lesson: [Variance and Volatility Swaps](https://learn.tradelabsai.com/volatility/variance-and-volatility-swaps/) - Previous lesson: [Dispersion and Correlation Trading](https://learn.tradelabsai.com/volatility/dispersion-trading/) - Related: [Dispersion and Correlation Trading](https://learn.tradelabsai.com/volatility/dispersion-trading/): Dispersion trading sells index volatility and buys volatility on its member stocks, betting on correlation. Learn the logic, implied correlation and the risks. - Related: [Volatility Trading](https://learn.tradelabsai.com/volatility/volatility-trading/): Volatility trading profits from the size of price moves, not their direction. Learn implied vs realised bets, the main instruments and how to manage risk. - Related: [Delta Hedging](https://learn.tradelabsai.com/options/delta-hedging/): Delta hedging offsets an option position's directional risk with the underlying. Learn how it works, how often to rehedge and what risk remains. - Related: [Gamma Scalping](https://learn.tradelabsai.com/options/gamma-scalping/): Gamma scalping buys options and repeatedly delta hedges to lock in gains from price swings. Learn how it works, the break even move and when it pays. - Related: [GARCH](https://learn.tradelabsai.com/math/garch/): GARCH models capture volatility clustering, where big moves follow big moves. Learn the GARCH(1,1) formula, persistence, forecasting and uses in risk and options. - Related: [Historical and Realized Volatility](https://learn.tradelabsai.com/volatility/historical-volatility/): Historical volatility measures how much a price actually moved, using past returns. Learn the standard formula, range based estimators and how traders use it.