Option replication is a dynamic hedging process that some options traders use to balance their exposure to underlying volatility and time decay (theta). For option buyers, this process looks like buying breaks and selling rallies. For option sellers, the reverse is true. However, in both cases, traders rebalance their delta exposure as the market moves.

Option owners can lean on the long gamma in their position to repeatedly trade in the underlying while buying breaks and selling rallies. The option owner attempts to harvest market volatility through this process to offset time decay. Suppose option buyers can reap more volatility from the marketplace than the implied-volatility price they paid for their options. In that case, the net result should be profits. If option buyers realize less volatility than they paid for their options, the result will likely be losses.

Option sellers generally buy rallies and sell breaks in the underlying to manage their changing exposure. A runaway market should be an option seller's biggest fear, and hedging in this way can protect against this fear. It is likely that buying rallies and selling breaks will result in negative cash flow. However, option sellers hope the time decay they collect will offset the whipsaw of hedging their short options. If option sellers realize less volatility in the marketplace than the implied-volatility price of the options they sold, they should have profits. Suppose option sellers realize more volatility in the market than the implied volatility level they sold. In that case, they are likely to experience losses.

By using an option replication strategy, both option buyers and sellers attempt to make their bets more about market volatility rather than direction. Ultimately, option buyers hope the market will be more volatile than implied by the price of the options they buy, and sellers hope for the opposite. In this way, option replicators become volatility traders.

A robust option hedging model is all but essential to effective volatility trading. Beyond an adequate model, volatility traders should have discipline and experience. No model is perfect, and all models are only as good as the traders using them. We recommend that anyone considering volatility trading seeks qualified guidance from an experienced volatility trader. There are many pitfalls in the learning process, and markets generally charge the self-taught dearly for their lessons.