I don’t need to tell you that the stock market’s been on a wild ride these last few weeks.
But going back even further, since about mid-2024, the VIX has been regularly popping up into the 20s, in contrast to the sleepy teens we saw in the first half of that year.
So what’s happening with the volatility risk premium (VRP) during all this excitement?
What exactly is the volatility risk premium?
When you look at stock options, their prices tell us something important – what the market expects volatility to be. This expectation, extracted from option prices, is known as implied volatility.
Here’s the interesting part: when you go back and compare what actually happened (realized volatility) with what the market thought would happen (implied volatility), you discover something curious:
The market tends to price in more volatility than it gets.
This gap between implied and realized volatility is the Volatility Risk Premium (VRP).
It’s similar to the Equity Risk Premium (ERP), but it compensates for a different kind of risk. When investors sell options, they expose themselves to potential losses if market volatility spikes. The implied volatility contains a premium, on average, as compensation for taking on this risk.
A real-world analogy
Let’s break this down with two money-making ventures:
- Renting out property (a bit like ERP): You buy a house and rent it out. Every month, you collect rent. The house value might fluctuate, but your rent is relatively steady. Over the long run, you expect profit, even with the occasional tenant who trashes the place. This consistent return above what you’d get from a bank account is analogous to the Equity Risk Premium.
- Selling Insurance (a bit like VRP): Imagine you sell storm insurance. Most years, no catastrophic storms hit, and you pocket all the premiums. But occasionally, a massive storm strikes, and you pay out huge claims. The money you earn in storm-free years is your reward for the risk you take during those rare devastating events. This difference between collected premiums and occasional payouts mirrors the Volatility Risk Premium.
The property rental (like investing in stocks) offers a relatively consistent return. You face some risks but expect rewards over time for taking them on.
Selling storm insurance works like selling options. Most of the time, you collect premiums, but periodically, a “storm” hits, and you pay out big. The difference between your regular premium collection and those rare, massive payouts represents capturing the VRP.
Both premia exist as compensation for risk, but there are crucial differences:
- Nature of risk: ERP compensates for the general risk of equities, while VRP compensates for the risk of volatility spikes.
- Duration: ERP is typically viewed with a longer-term perspective, whereas VRP can be particularly noticeable in the short term due to immediate market uncertainties.
What does the VRP look like in practice?
VIXY is an ETF that holds short-term VIX futures. Because of the VRP, it loses money most of the time (since realized volatility typically comes in lower than implied) but occasionally spikes dramatically.
If you’d shorted $1,000 of VIXY at inception and continuously compounded by reinvesting profits daily (ignoring fees), you’d have made and lost a ton of money. You made a little money most of the time, but when volatility spiked, VIXY spiked too, and your short position would get absolutely hammered, sometimes catastrophically.
This illustrates how differently the VRP behaves compared to the ERP. It requires much more careful management.
Here’s how this would have looked if you’d constantly rebalanced to your original $1,000 exposure (without transaction costs):
Selling volatility has been a good bet on average, but it’s been a roller coaster and blown up many short volatility traders along the way.
So what’s happening now?
One way to estimate the VRP is to take the implied vol at the start of the month (the VIX) and subtract the monthly realized vol, calculated as the annualized standard deviation of SPY’s log returns.
Looking at this data since 1990, we see that it’s been all over the place, but positive on average:
The red line represents monthly VRP snapshots, the blue line is the rolling 12-month average of these snapshots, and the horizontal black line is the average premium.
And zooming in on recent years, we can see that the VRP has been quite low lately – even turning negative on a 12-month rolling basis:
This matches what we’ve been experiencing, where short volatility trades seemed to get really crowded in 2023-2024. We’ve been more selective in our short volatility trading recently, which has helped somewhat, but it’s still a challenging environment.
One obvious explanation for the low or negative VRP is simple: while implied volatility has been up, realized volatility has been up too. Just because the VIX is elevated doesn’t mean you’ll be rewarded for selling volatility. In fact, the opposite can be true, depending on how accurately the market is pricing volatility.
What should you do with this information?
The market’s been all over the place, and that’s reflected in both implied and realized volatility. The premium for taking on volatility risk just isn’t as juicy as it has been historically.
Remember that the VRP behaves very differently from the ERP. Those big spikes in volatility can destroy months or even years of steady gains if you’re not careful with position sizing.
If you’re trading short volatility strategies, be cautious. While I would bet on a return to a positive VRP, it remains stubbornly low for now. My volatility positions are currently smaller than usual and I’m being more selective about selling vol (for instance, using volatility of volatility as a filter and looking at some perhaps less crowded regions on the term structure).
