Options Math for Traders: How To Pick the Best Option Strategies for Your Market Outlook, + Website

CHAPTER 5

The Volatility Risk Premium

Over the long run, options cost more than they are worth. Period. Academics have studied the how much and the when to death, but the what is pretty much a given. Options, as measured by implied volatility, cost more than they are ultimately worth, as measured by realized volatility. The difference is the volatility risk premium.

Intuitively, this makes tremendous sense in part because option payoffs are hugely asymmetrical. Option buyers have a relatively small risk, the price paid for the option, and have a theoretically gigantic potential return; if they’ve bought a call option then the potential return is essentially infinite. On the other hand, option sellers have a relatively small potential return, the amount received for selling the option, and a theoretically gigantic potential risk; if they’ve sold a call option then the potential risk is essentially infinite. We’d expect the option sellers to make some profit to compensate for this asymmetry, and most people wouldn’t begrudge them a reasonable one. But what is a reasonable profit? Why don’t some who are willing to reap a smaller profit sell down option prices? Why does this volatility risk premium continue to exist, and is there an empirical reason that it is what it is?

VOLATILITY RISK PREMIUM, THE WHAT

For option buyers, implied volatility is what they pay. For option buyers the realized volatility is what they actually get. The volatility risk premium is the difference between ...