Implied vol is 30%, you think realized will be 20%

Question

An at-the-money option is trading at an implied volatility of $30\%$ , but your forecast for the volatility the underlying will actually realize over the option's life is $20\%$ .

What is the trade, how do you isolate the volatility view, and where is the risk?

Accepted Answer

The core trade: sell the option (sell vol). Implied volatility is what the market is charging for the underlying's future movement. If you believe realized vol will be 20\% but you're paid as if it will be 30\%, the option is expensive relative to your forecast, so you sell it. Selling an option is being short volatility: you profit if the underlying moves less than the implied amount. Isolate the vol bet with delta hedging. A naked short option also carries a directional (delta) exposure, you'd make or lose money simply from the underlying drifting, which has nothing to do with your vol view…

Implied vol is 30%, you think realized will be 20%

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