What Is the Volatility Risk Premium? Implied vs Realised Volatility

What Is the Volatility Risk Premium?

The volatility risk premium (VRP) is commonly used to describe the difference between the volatility implied by option prices and the volatility subsequently realised by the underlying asset over a comparable period. In many markets and periods, implied volatility has tended to exceed realised volatility, partly because option buyers may pay for protection against uncertain or extreme outcomes.

The difference is not constant and can be negative. The result depends on the market, time period, measurement method and the particular option being analysed.

Implied Volatility vs Realised Volatility

Implied volatility (IV) is the volatility input consistent with an option's market price under a pricing model. It reflects market pricing, not a guaranteed forecast.

Realised volatility measures how much the underlying actually moved over a historical or observed period, using a specified calculation method.

For more detail, read What Is Implied Volatility? and What Is IV Rank?.

A Simplified Illustration

Suppose an option's implied volatility is 24%, while the underlying later realises volatility of 18% over a comparable period. The implied-minus-realised difference is 6 percentage points. This is an illustration of the comparison, not a guaranteed premium that an option seller earns.

The option's profit or loss also depends on the underlying price path, strike, expiry, changes in IV, transaction costs, hedging and the exact position. A trader can lose money even when realised volatility ends up below the IV observed at entry.

Why Might Implied Volatility Be Higher?

Options can provide protection against unfavourable price moves, including sudden gaps that are difficult to hedge continuously. Buyers may be willing to pay for that protection. Sellers accepting the other side of the exposure take on risks that are not captured by a simple average-volatility comparison, including jumps, skew, liquidity and tail events.

The VRP can therefore be viewed as compensation that option sellers may receive for bearing volatility-related risks—not as free or assured income.

Why High IV Does Not Automatically Mean “Sell Options”

A high IV reading can reflect genuine event risk or a market that is expected to move sharply. If a large move occurs, the option seller's loss can exceed premium received. A trader must consider the direction of the move, the payoff structure, position size, margin, skew, expiry and whether the option is liquid enough to manage.

Likewise, low IV does not guarantee that buying options is attractive. The price may still be expensive relative to the move that eventually occurs.

How Traders Study the Volatility Risk Premium

A careful analysis should:

1.Compare IV with realised volatility over a consistent horizon.

2.Avoid comparing unlike measures or mismatched time periods.

3.Examine different strikes and expiries, not just one headline IV number.

4.Include transaction costs, bid-ask spreads and hedge costs.

5.Evaluate drawdowns and tail events, not only average returns.

6.Backtest with realistic execution assumptions and out-of-sample data.

Common Misconceptions

“IV is always a forecast of future volatility.”

IV is derived from market prices and model assumptions. It is informative, but not a guaranteed prediction.

“If IV is above realised volatility, every short option wins.”

No. Individual trades can lose due to price direction, jumps, changes in IV, skew, costs and position design.

“The volatility risk premium is the same every month.”

No. It varies across time, products, market regimes, strikes and expiries.

Frequently Asked Questions

Can the volatility risk premium turn negative?

Yes. Realised volatility can exceed the implied volatility priced into options, and the difference varies across periods and markets.

Is VRP useful for an options strategy?

It can be one input in research and risk analysis, but it should be combined with payoff analysis, liquidity, event risk and realistic trading costs.

Does a positive VRP guarantee an option-selling strategy will profit?

No. A positive average difference does not guarantee the outcome of any individual trade or strategy.

Disclaimer

This article is for educational purposes only and does not constitute financial advice. Options trading can lead to substantial losses, including losses greater than premium received. Verify current market data and contract rules before trading.