Volatility Risk Premium
The structural tendency for implied volatility to overstate actual subsequent market moves — the core reason options selling has a long-run statistical edge.
Definition
The volatility risk premium (VRP) is the difference between the implied volatility priced into an option at the time of purchase and the realised volatility that the underlying actually delivers over the life of that option. Across long samples in equity index markets, IV tends to run 2–5 percentage points above subsequent realised volatility on average, meaning buyers systematically overpay for the volatility component of their options. This gap is not an arbitrage — it compensates sellers for taking on left-tail risk — but it creates a durable statistical edge that systematic option-selling strategies attempt to harvest.
Why it matters
The VRP is the theoretical foundation behind the large community of option sellers in India's F&O markets. When a trader sells a short strangle on Nifty or Bank Nifty and collects 1.5% of the notional as premium, they are essentially wagering that the underlying will realise less volatility than the market has implied. Over time, if IV persistently exceeds realised vol, the strategy collects more premium than it pays out in losses. However, the VRP is not constant — it compresses during low-volatility regimes and can temporarily flip negative during crises when actual moves exceed any prior IV. India VIX is a commonly watched proxy: when India VIX is very high, the VRP earned by sellers tends to be large but so is the risk of a tail event that overwhelms the collected premium. SEBI's peak margin rules and SPAN requirements are designed precisely to ensure sellers maintain adequate capital against these tail scenarios.
Formula
VRP = IVt − RVt, t+N
where IVt is the implied volatility at entry (annualised), and RVt, t+N is the annualised realised volatility of the underlying from time t to expiry at t+N. A positive VRP means the market overpriced volatility; a negative VRP means realised moves exceeded expectations.
Example
Say a Nifty 50 monthly option is sold when at-the-money IV reads 16% annualised. Over the following 30 calendar days, Nifty realises daily moves that, when annualised, equate to 11%. The VRP harvested on this trade is 16% − 11% = 5 percentage points. Conversely, if a surprise event causes Nifty to realise 24% volatility in that window, the VRP is −8% — the seller received less premium than the risk warranted. These numbers are hypothetical; actual VRP varies significantly by market regime and event calendar.
Monitor IV vs realised vol on TradePulse
Track implied volatility across strikes and tenors to judge whether current premiums are rich or fair.