The Volatility Spread Strategy is a market-neutral trading approach that seeks to profit from the difference in volatility between two related assets or markets. By exploiting discrepancies in implied volatility (IV) or realised volatility (RV), traders can create positions that benefit from volatility convergence or divergence over time. This strategy is most commonly used in options markets, but it can also be applied in futures or forex markets where volatility plays a key role in price movements.

Primarily used by institutional traders, hedge funds, and market makers, the Volatility Spread Strategy capitalises on volatility mispricing, where the implied volatility of a given asset is not aligned with its realised volatility or expected future volatility.

What Is Volatility Spread?

The volatility spread refers to the difference between the implied volatility of an asset (as derived from options pricing) and its realised volatility (the historical volatility of its price). Traders aim to exploit situations where these two measures of volatility diverge.

• Implied Volatility (IV): The market’s expectation of how volatile an asset will be in the future, derived from options prices.
• Realised Volatility (RV): The actual observed volatility of an asset over a specified time period.

The strategy can be employed by either trading volatility directly (through options) or trading the difference between volatilities (such as between related asset pairs).

Strategy Mechanics

1. Identifying Volatility Discrepancies

The core of the Volatility Spread Strategy lies in identifying when implied volatility does not align with realised volatility. This can happen for several reasons:

• Option overpricing or underpricing: When IV deviates significantly from RV, options may be overpriced or underpriced.
• Volatility spikes: An unexpected event may cause IV to spike temporarily, creating an opportunity for RV to revert.
• Mean reversion: Historically, volatility tends to revert to a long-term mean. A sharp rise or drop in IV compared to RV often signals an opportunity to profit as the volatility converges.

2. Volatility Spread Trade Setup

To set up a volatility spread:

• Step 1: Compare implied volatility and realised volatility over the same time frame for the target asset.
• Step 2: Identify if implied volatility is higher or lower than realised volatility.
  • If IV > RV, implied volatility is overpriced, and an opportunity exists to sell options or implement strategies that benefit from IV contraction.
  • If IV < RV, implied volatility is underpriced, and a strategy that benefits from IV expansion (such as buying options) can be used.
• Step 3: Set up a position in either the options or futures markets based on the volatility expectation. This could involve:
  • Option spreads (bull or bear)
  • Straddle or strangle positions
  • Volatility swaps or futures contracts

3. Trade Execution

• Option strategies: If implied volatility is high, a trader might sell an option spread (e.g., a credit spread) to capture premium decay. Conversely, if implied volatility is low, a trader might buy a volatility spread (e.g., a debit spread) to take advantage of volatility expansion.
• Futures positions: If volatility is expected to rise, traders can take long positions in volatility futures (e.g., VIX futures). If volatility is expected to decrease, short positions in volatility futures can be employed.
• Time decay (Theta): In a high IV environment, options sellers may benefit from time decay. In a low IV environment, options buyers may benefit from an increase in volatility.

4. Exit Strategy

• Realised volatility reverts: Close the position when implied volatility converges with realised volatility or when it reaches a predefined target.
• Profit-taking: Exit when the volatility spread reaches a predetermined level of profit, or when there is a change in market conditions that impacts future volatility expectations.

Example: EUR/USD Volatility Spread

Suppose EUR/USD has options with a high implied volatility (IV) relative to its realised volatility (RV). The trader believes that the market is overestimating future volatility.

• Step 1: The trader notices that the implied volatility is 15%, while the realised volatility over the past month was 8%.
• Step 2: The trader expects volatility to revert and IV to decrease.
• Step 3: The trader executes a short strangle by selling both a call and a put option on EUR/USD with a strike price 100 pips away from the current market. The premium received is the primary source of profit as volatility converges.
• Step 4: The trader monitors the position until volatility levels return to more typical levels, at which point they close the trade.

Tools and Technologies

• Volatility data feeds: Real-time IV and RV data from platforms such as Bloomberg, Reuters, or CME Group.
• Trading platforms: MetaTrader 5, ThinkorSwim, or Interactive Brokers for options and futures execution.
• Analytics: Quantitative analysis tools (R, Python) to assess volatility over different time frames and monitor spread changes.
• Backtesting platforms: QuantConnect, Backtrader, or custom Python backtest engines for testing volatility-based strategies.

Advantages

• Market-neutral: The strategy is not directional and thus avoids exposure to the overall market trend.
• Profit from volatility convergence: Can be profitable regardless of the underlying asset’s price direction.
• Low capital requirement: Can be implemented with minimal capital, especially through options spreads and volatility futures.
• Works well in volatile environments: Ideal for periods of market stress or uncertainty when volatility expectations tend to overshoot or undershoot.

Limitations

• Requires accurate volatility forecasting: Predicting volatility can be difficult, especially in fast-moving markets.
• Transaction costs: Frequent trading of options or futures contracts can incur significant transaction costs, reducing profitability.
• Time sensitivity: The strategy requires precise timing, as volatility spreads may change rapidly due to external market factors.

Best Markets for Volatility Spread Trading

• EUR/USD, GBP/USD, USD/JPY: These major currency pairs tend to have more predictable volatility patterns and liquid options markets.
• Equities and equity indices: Trading volatility spreads in stocks or indices (e.g., S&P 500, Nasdaq) can be very effective, particularly with options.
• Cryptocurrency markets: Cryptos are known for their high volatility, which creates unique opportunities for volatility spread trading.
• Volatility indices: Trading instruments like VIX futures or VIX options can be part of a volatility spread strategy.

Conclusion

The Volatility Spread Strategy is a powerful tool for traders who want to capitalise on changes in volatility between implied and realised measures. By strategically positioning in options or futures, traders can profit from volatility mispricing, making it an essential strategy in uncertain or volatile markets.

To learn how to develop and implement volatility spread strategies, backtest models, and execute trades across various instruments, enrol in the expert-led Trading Courses at Traders MBA.