Implied vs Realized Volatility
The gap between what the market expects and what actually happens — and why it is the edge that most option sellers are really collecting.
Definition
Implied volatility (IV) is the forward-looking volatility extracted from current option prices via a pricing model — the market's consensus on how much the underlying will move before expiry. Realized volatility (RV), also called historical or statistical volatility, is the actual annualised standard deviation of returns over a past period, calculated from closing prices. The difference — IV minus RV — is the volatility risk premium (VRP). On most underlyings, IV tends to exceed RV on average, meaning the market chronically overestimates future movement. This persistent overestimation is the structural edge that option sellers harvest through time decay, while option buyers pay for insurance and asymmetry. Understanding the relationship between the two is fundamental to choosing between buying and selling strategies.
Why it matters
The IV-RV gap is the most important volatility concept for systematic traders. When IV significantly exceeds the realised vol over the same period, premium sellers collected more than the move warranted — the classic outcome of short straddles and iron condors on NSE weekly expiries. When RV exceeds IV (rare but real during sudden crises — the 2020 COVID crash, the 2022 Russia-Ukraine spike, or abrupt RBI surprise announcements), option sellers face outsized losses and option buyers reap large payoffs. Practically, traders compare the current ATM IV against the 20-day or 30-day realized volatility to assess whether premium is fair: if IV is 18 percent and 30-day RV is 11 percent, the market is implying 64 percent more movement than recently occurred — suggesting premium sellers have an edge, provided no large event is imminent. Conversely, if IV and RV are nearly equal, there is no VRP cushion and selling strategies carry more directional risk.
How it works
Realized volatility is computed from daily log-returns: RV = √(252 × (1/N) × ∑ ri²), where ri = ln(Closei/Closei−1) and N is typically 20 or 30 days. Implied volatility is read from the ATM option mid-price for the matching expiry. The VRP is then IV − RV, often smoothed with a rolling window to reduce noise. Some traders also monitor the India VIX against a 30-day realised vol of Nifty as a macro-level VRP gauge, since VIX is computed from a cross-section of strikes rather than a single ATM option.
Example
Suppose Nifty's 30-day realised volatility on a Monday is 12.5 percent, and the ATM IV for the current monthly expiry (28 days away) is 17.8 percent. The VRP = 17.8 − 12.5 = 5.3 percentage points. A trader sells a Nifty ATM straddle collecting ₹420 in premium. If Nifty moves with 12.5 percent realised vol over the next 28 days — in line with recent history — the straddle should decay and expire worth roughly ₹280, generating ₹140 profit per lot. If a surprise event causes realised vol to jump to 22 percent, the straddle may expand and the trade loses. The VRP is never a guaranteed profit — it is a probabilistic edge that requires consistent execution and disciplined sizing. All numbers are hypothetical.
Monitor IV vs RV on TradePulse
TradePulse tracks live ATM IV and realised volatility on Nifty side-by-side, giving you an instant read on whether the VRP favours buyers or sellers today.