Direct Answer
The volatility risk premium is the gap between implied volatility (or implied variance) and the volatility subsequently realized. It is the compensation option sellers have historically earned on average for bearing volatility risk. On average the premium has been positive for equity indexes, meaning implied volatility has exceeded what was later realized.
Volatility Risk Premium: Formula, Meaning, Signals, Examples and How to Use It
How Is Volatility Risk Premium Calculated?
The volatility risk premium is the gap between implied volatility (or implied variance) and the volatility subsequently realized. It is the compensation option sellers have historically earned on average for bearing volatility risk.
Formula: VRP = IV^2 - RV^2 in variance terms (or IV - RV in volatility points), where RV is measured over the period the option covered
Inputs:
- Implied volatility at the start of the period (for example a 30-day index level)
- Realized volatility over the same period
- Consistent annualization
Worked example. An implied volatility of 20 points and a realized volatility of 15 points give a variance premium of 175 squared volatility points. The inputs are illustrative numbers, not market data.
Reading it. On average the premium has been positive for equity indexes, meaning implied volatility has exceeded what was later realized. In any single period it can be negative, especially in sharp sell-offs.
Limits. It can only be computed after the period ends, using realized volatility from the same window, so it is a historical measure. The result depends on the implied measure, the realized estimator and the sample period.
What is Volatility Risk Premium?
The volatility risk premium is the gap between implied volatility (or implied variance) and the volatility subsequently realized. It is the compensation option sellers have historically earned on average for bearing volatility risk.
How to use Volatility Risk Premium
On average the premium has been positive for equity indexes, meaning implied volatility has exceeded what was later realized. In any single period it can be negative, especially in sharp sell-offs. A reading alone is never a buy or sell signal; it needs context from price structure, volume, volatility and the broader market regime.
Strengths
- Subtracting realized from implied variance puts the compensation for bearing variance in one number, with the same units on both sides.
- Matching realized volatility to the period the option covered keeps the two terms on about the same time span.
- Reproducible when the formula and data convention are fixed.
Weaknesses and limitations
- Variance terms and volatility-point terms give different magnitudes, so a premium quoted in one form cannot be compared with the other.
- Realized variance is skewed by rare large moves, so the average premium can be positive while individual periods are strongly negative.
- Correlated indicators can create false confidence by repeating the same underlying information.
Editorial and risk note
This page is educational content, not individualized investment advice. It should not imply guaranteed prediction, accuracy or outperformance.
Frequently Asked Questions
Is Volatility Risk Premium a buy or sell signal?
No. On average the premium has been positive for equity indexes, meaning implied volatility has exceeded what was later realized. It can only be computed after the period ends, using realized volatility from the same window, so it is a historical measure. A trade built on it still needs a trigger, an invalidation rule, a position size and realistic execution assumptions.
What is the best setting for Volatility Risk Premium?
Volatility Risk Premium takes these inputs: implied volatility at the start of the period (for example a 30-day index level); realized volatility over the same period; consistent annualization. There is no universal best setting for the tunable ones, so test them across instruments, regimes and out-of-sample periods and favor stable parameter regions over one historical winner.
Can Volatility Risk Premium be used by itself?
It can only be computed after the period ends, using realized volatility from the same window, so it is a historical measure. The result depends on the implied measure, the realized estimator and the sample period. For that reason it is read next to measures of direction, participation, valuation, liquidity and risk, not alone.
Does Volatility Risk Premium work on every timeframe?
The calculation (VRP = IV^2 - RV^2 in variance terms (or IV - RV in volatility points), where RV is measured over the period the option covered) can be run on any bar size, but behavior is not portable: a reading on a five-minute chart describes a very different market window from the same reading on a daily chart. Validate the exact timeframe before relying on it.
Why does Volatility Risk Premium give false signals?
Variance terms and volatility-point terms give different magnitudes, so a premium quoted in one form cannot be compared with the other. Realized variance is skewed by rare large moves, so the average premium can be positive while individual periods are strongly negative. Lag, noise and regime changes add to this, because market participants react to new information after the reading is calculated.
How should Volatility Risk Premium be backtested?
Rebuild Volatility Risk Premium from implied volatility at the start of the period (for example a 30-day index level) using point-in-time data, write the rules before testing, include delisted securities where relevant, model realistic fills and costs, reserve a validation sample and compare with a simpler baseline.