Volatility Risk Premium: Measurement, Short Volatility Risks, and Recent Weakness

Summary

The volatility risk premium (VRP) is the tendency for option implied volatility to exceed the volatility that later occurs. The article explains this as compensation for bearing the risk of sharp volatility spikes, comparing option selling to insurance: frequent premium income can be overwhelmed by occasional large losses. It uses short exposure to VIXY, an ETF holding short-term VIX futures, to illustrate why volatility selling can be profitable on average yet suffer severe drawdowns.

For a simple estimate, it compares the VIX at the start of each month with annualized realized volatility from SPY log returns. The historical snapshots since 1990 show a positive average, while the recent rolling 12-month measure has been low or negative. The author attributes this partly to realized volatility rising alongside implied volatility and describes reducing short-volatility exposure, filtering with volatility of volatility, and considering less crowded term-structure areas. The estimate is a simplified monthly comparison, and the article emphasizes that average premium does not ensure gains or protect against catastrophic losses; sizing and selectivity matter.

Key ideas

• The VRP is the gap between implied volatility and subsequent realized volatility, and it compensates sellers for taking volatility risk.
• Short volatility can collect gains repeatedly but remain exposed to occasional losses large enough to erase prior profits.
• A basic monthly estimate subtracts realized SPY volatility from the VIX observed at the beginning of the month.
• The article reports that this estimate has been positive on average since 1990 but recently low or negative on a rolling basis.
• Elevated implied volatility alone is not a sufficient reason to sell volatility when realized volatility is also high.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.