This strategy involves trading of listed equity options judged by an objective valuation model to be mispriced. In an arbitrage trade, risk is minimized by buying cheap options likely to appreciate in value and simultaneously selling a like amount of expensive options likely to decline in value while keeping neutral the net exposure to movement in the price of the underlying security (i.e., maintaining delta neutrality). Either leg of the trade may be implemented with listed options or with a continuously traded delta hedge of the underlying security. The manager does not care about the direction of the market; his concern is whether he has judged correctly how realized volatility will move relative to the implied volatility of his option positions. Implied volatility is the key feature on which options trade. The remaining inputs to option valuation, underlying security price, exercise price, time to expiry and discount rate, are easily observable.
