Implied vol is 18%, you think realized will be 28%

Question

An at-the-money option trades at an implied volatility of $18\%$ , but your forecast for the volatility the underlying will actually realize over the option's life is $28\%$ .

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

Accepted Answer

The core trade: buy the option (buy vol). Implied volatility is the price the market charges for future movement. You believe the underlying will move more (28\%) than the market is charging for (18\%), so the option is cheap relative to your forecast. You buy it. Buying an option is being long volatility: you profit if the underlying moves more than the implied amount. Isolate the vol bet with delta hedging. A naked long option also carries a directional (delta) exposure, you would make or lose money simply from the underlying drifting, unrelated to your vol view. To strip that out, hold -\D…

Implied vol is 18%, you think realized will be 28%

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