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SVQ · Volatility

Volatility risk premium (VRP)

Also called: VRP, variance risk premium, implied minus realized volatility

The volatility risk premium is the typical gap between implied volatility and the volatility that is later realized, a price for bearing volatility risk.

Definition

The volatility risk premium (VRP) is the difference between the volatility priced into options (implied) and the volatility the underlying subsequently delivers (realized). In variance terms it is often called the variance risk premium.

Across many markets and long samples, implied volatility has on average exceeded later realized volatility, so the premium is usually positive, but it varies over time and turns sharply negative in shocks.

Intuition

Option buyers pay for protection against large moves and volatility spikes, and option sellers demand compensation for carrying that risk, which tends to hit hardest exactly when other assets are falling. The premium is the insurance margin.

For traders the VRP frames a basic question: is the market charging more for volatility than it is likely to deliver? The answer is only known after the fact, which is why the premium is a risk and not a costless source of return.

How it's calculated

Ex-post, over a horizon of N trading days:

VRPt = σimplied,t² − σrealized,t→t+N²

or in volatility terms σimplied − σrealized. Implied volatility is taken from at-the-money options or a model-free variance measure for the same horizon; realized volatility is computed from returns over the following N days and annualized.

A current-period proxy replaces the unknown future realized volatility with trailing realized volatility or a forecast (for example from a GARCH model). The proxy is easier to compute but mixes the premium with forecast error.

Example: if 30-day implied volatility is 18% and the following 21 trading days realize 14%, the premium is 4 volatility points, or 0.18² − 0.14² = 0.0128 in annualized variance.

How to read it

A wide positive gap means options look expensive relative to recent or expected movement. A negative gap means realized movement is outrunning what options price, which is common in the early part of a sell-off.

Compare horizons consistently: 30-day implied against the following 21 trading days (about 30 calendar days), not against a trailing window of a different length. Look at the premium relative to its own history for the asset.

Common mistakes

  • Treating a positive VRP as a guaranteed edge for selling options; the losses in volatility spikes can exceed years of premium.
  • Comparing implied volatility with trailing realized volatility and calling it the premium, without noting the look-back mismatch.
  • Mixing variance and volatility units.
  • Ignoring jumps and scheduled events that the implied side prices and the realized window may or may not contain.

In Saqrid

SVQ shows a per-symbol volatility risk premium together with a Crash-O-Meter reading of put-skew crash fear.

Open SVQ.

  • Realized volatilityRealized volatility measures how much an asset actually moved; close-to-close, Parkinson, Garman–Klass and Yang–Zhang estimators use different price data.
  • IV rankIV rank places current implied volatility within its own past range, from 0 at the period low to 100 at the period high.
  • GARCHGARCH models volatility that clusters: today's variance depends on yesterday's squared shock and yesterday's variance, reverting to a long-run level.
  • Put skew and crash riskPut skew is the extra implied volatility on downside strikes, a market price for crash risk that rises when demand for protection grows.

Go deeper

Saqrid Institute lesson: Comparing Volatilities: Implied vs Realized (VRP). Lesson text is open to read without an account.

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