Trading Volatility Through Options, Swaps, and Delta Hedging
Summary
The document discusses what traders mean by spot volatility and how it can be expressed through traded instruments. It presents several interpretations: volatility swaps can provide exposure linked to realized volatility; options can express implied volatility, including forward volatility; and front-month options are described by one respondent as a proxy for nearer-term, or spot, volatility. The answers therefore treat volatility as an exposure constructed through instruments rather than as an asset traded directly.
A further explanation describes holding options and delta-hedging with the underlying, which creates P/L sensitive to realized price variation and can be compared with the option’s implied volatility. The responses differ in how they distinguish spot from forward volatility, and the discussion does not specify contract mechanics, hedge frequency, costs, or risks. It is a conceptual overview of possible exposures, not a complete arbitrage strategy or evidence that implied volatility will exceed realized volatility.
Key ideas
- Volatility exposure is accessed through instruments rather than by trading volatility as a standalone asset.
- A volatility swap can provide exposure linked to realized volatility.
- Options provide exposure to implied volatility, and their maturities shape the volatility horizon.
- Delta-hedged options can create P/L that responds to realized movements in the underlying.
- The document presents differing views on whether front-month options represent spot volatility.
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Full text
# Trading spot volatility # Trading spot volatility I am reading a paper that very briefly talks about some volatility arbitrage strategies. It's so brief that I do not exactly understand how it works. It says one of the strategy is based on "short spot index volatility, long on implied volatility" on the premise that IV > realized volatility. I know how one can trade implied volatility (using a delta-hedged option portfolio), but how can I trade spot volatility? The other arbitrage strategy is supposedly based on volatility smile: "short stock smile, long stock volatility". So unless there is a way to trade spot volatility, this seems like a contradiction. Is there any way to trade spot volatility? ## Answer by nicolas (score 2) https://quant.stackexchange.com/a/10879 you never directly trade spot volatility per se, you exchange it for something else : - if you want to exchange it for spot implied volatility, you buy a volatility swap. - if you want to exchange it for forward implied volatility you get options. ## Answer by deprecated (score 2) https://quant.stackexchange.com/a/11129 nicolas is quite right. For completeness, AccuShares has registered new products (the VIX Up and VIX Down shares, filing here) which are designed to track spot VIX. However, this approach has not worked out particularly well in the past (consider UCR and DCR). ## Answer by user263367 (score 2) https://quant.stackexchange.com/a/14962 I do not agree with nicolas. I think that spot volatility is represented by the front month expiry options while future volatility is represented by e.g. VIX and VSTOXX which are inherently based on a mix with options in further expiries. Please also see the interview in the The Trader Derivatives: "...because they (Volatility futures like VIX) represent forward volatility while index or equity options are spot volatility" http://www.thetrade-derivatives-digital.com/thetradederivatives/issue_8_q3_2014#pg78 ## Answer by onlyvix.blogspot.com (score 2) https://quant.stackexchange.com/a/26158 The first thing you have to understand that volatility is an abstraction, and there are different possible implementations of this abstraction in terms of trading. When someone writes "short spot index volatility, long on implied volatility" they mean something like take a position in options (implied vol) and delta hedge in the underlying instrument, which creates an offsetting P/L with "spot" (underlying) volatility.
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