The volatility risk premium: why selling volatility has historically been profitable

The implied volatility embedded in equity option prices has, on average, exceeded the volatility actually realised over the option's life. The systematic gap between the two is the volatility risk premium: a payoff that accrues to the seller of options (or the seller of variance, in derivatives form) and that has been one of the most reliably profitable systematic strategies in modern markets—at the cost of catastrophic exposure in the worst episodes.

What the volatility risk premium is

An option's price reflects the market's pricing of expected volatility over the option's life. The realised volatility actually delivered by the underlying asset is, on average, lower than the implied volatility priced into the option at issuance. The systematic gap—implied volatility above realised volatility—is the volatility risk premium, paid by option buyers and earned by option sellers.

The gap exists because volatility itself is a risky asset, and option sellers demand a premium for bearing it. Like the equity risk premium, the volatility risk premium is compensation for taking risk that someone else does not want to bear. The party who bears it (the option seller) earns a positive expected return; the party who hedges with it (the option buyer) pays a premium that exceeds the expected payoff.

For US equity index options, the average implied volatility (as measured by the VIX index) has been approximately 4–6 percentage points above the contemporaneous realised volatility over the post-1990 period. Selling volatility systematically—through short variance swaps, short straddles, or short volatility ETP positions—has captured this premium over long horizons.

How it works

The cleanest expression of the volatility risk premium is a short variance swap: a contract that pays out the difference between strike volatility (set at issuance) and realised volatility over the contract's life. Selling such a contract delivers the strike volatility minus the realised, which is positive in expectation because the strike (set roughly equal to implied volatility) tends to exceed the realised. The strategy is a direct claim on the volatility risk premium.

Short straddles—selling both a call and a put at the same strike—deliver a similar profile through option markets. The strategy collects premium upfront and pays out if the underlying moves substantially in either direction. In calm regimes, the strategy is steadily profitable; in vol spikes, it can lose multiples of the premium collected.

Short volatility ETPs (positions that profit from a falling VIX or from VIX futures rolling down a contango curve) are the retail-accessible version of the strategy. Several products are designed specifically to deliver the inverse of VIX-related performance, and they tend to produce attractive returns in calm regimes and catastrophic losses in vol spikes—as the February 2018 'volmageddon' episode demonstrated, when several inverse-VIX ETPs lost 80–95% of their value in a single day.

What the evidence shows

Carr and Wu (2009) document the volatility risk premium across major equity indices over 1996–2003, finding that the variance risk premium (the squared-volatility version) was reliably negative—implied variance exceeded realised variance—with risk-adjusted returns from short variance positions among the highest reported in any systematic strategy. Subsequent work has extended the analysis to longer windows and other asset classes (currencies, commodities, single stocks) with consistent results: implied volatility has been above realised volatility on average, with notable exceptions during sustained crisis periods.

The magnitude of the premium varies. In US equity options, the average gap is 4–6 percentage points but with substantial variation: in calm regimes, the gap can be 8–10 points; in periods of sustained turbulence, the gap can be small or negative as realised volatility spikes catch up with implied. Volatility-selling strategies therefore have time-varying expected returns, and the most profitable periods are paradoxically those just before a vol spike that destroys the position.

The drawdown profile of volatility-selling is the dominant practical concern. The 2008 crisis, the August 2015 China devaluation, the February 2018 vol spike, and the March 2020 COVID drawdown all produced multi-standard-deviation losses for short-volatility strategies. Some strategies recovered within months; others (the inverse-VIX ETPs in 2018) were closed entirely.

Limitations and trade-offs

The volatility risk premium is real but has a return profile that is the opposite of equity buy-and-hold: small steady gains punctuated by occasional large losses. Investors who size positions based on average historical volatility will systematically underestimate the tail risk, because the worst-case losses are far larger than the standard deviation suggests.

Position sizing is therefore the single most important practical question for any volatility-selling strategy. A position sized for normal-regime volatility can produce catastrophic loss in a tail event; a position sized for the tail produces returns that are too small to be worth the strategy's complexity. The reasonable middle ground is a small allocation that contributes positively to the portfolio in normal regimes and a tolerable loss in the worst case, sized so the worst case does not endanger the rest of the portfolio.

The strategy is also crowded. Many institutional investors (and a meaningful share of retail flow) sell volatility systematically, and the resulting positioning can amplify drawdowns when the trade unwinds simultaneously across participants. The February 2018 episode is the canonical example: the spike in VIX triggered margin calls and forced unwinds across short-vol positions, which pushed VIX even higher in a feedback loop.

Volatility risk premium in pfolio

pfolio supports volatility ETPs and VIX futures within the asset universe. Investors can express short or long volatility positions through these instruments; the platform's analytics display total return alongside roll cost contribution, making the carry component of any volatility position explicit in the constructed price series.

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• VIX and volatility investing explained: alternative assets and their role in a portfolio
• Futures explained: how futures contracts work and why they matter for commodity and currency exposure
• Tail risk hedging: practical approaches to limiting catastrophic loss
• Convertible arbitrage: hedging convertible bond positions to extract option value
• Implied vs realised volatility: what option prices say about expected risk versus what actually happens
• Options explained: calls, puts, and the basics of derivative contracts