How Does ‘Implied Volatility’ Differ from ‘Realized Volatility’ and How Can This Spread Be Arbitraged?

Implied volatility (IV) is the market's forecast of future price choppiness, derived from an option's price. Realized volatility (or historical volatility) is the actual price movement that occurs over a period.

Arbitrage opportunities arise when there's a significant spread between IV and what a trader expects the realized volatility to be. If a trader believes IV is too high, they can sell options (like a straddle or strangle) to collect the premium, betting that the actual price movement will be less than the market implies, thus profiting from the decay of the option's value.