Trading the difference between an option's implied volatility and the volatility the underlying is expected to realise, with directional exposure hedged away.
A trader believing implied volatility is too high sells options and delta-hedges, collecting premium and paying out on the hedge as the underlying moves. If realised volatility comes in below what was implied, the hedging cost is less than the premium received and the position profits.
Implied volatility has generally exceeded subsequent realised volatility, a persistent variance risk premium that compensates sellers for taking on crash exposure. Harvesting it therefore looks like collecting small regular gains punctuated by rare large losses, which flatters short track records.
Execution detail dominates results: hedge frequency, transaction costs, and how the position behaves when volatility and the underlying move together. See variance-swap and implied-volatility.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Delta across the range of prices. Delta says how much a call's price moves for a one-point move in the stock. Far below the strike it is near 0 and the option barely reacts; at the strike it is about 0.50; far above it approaches 1 and tracks the stock.The volatility smile. Options on the same stock and the same expiry are not priced off one volatility. Strikes near the money carry the lowest implied volatility, and it rises towards both ends — usually faster on the downside, which tilts the smile into a skew.
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