Volatility premium

The option strategies, which aim to capture a return premium over time as compensation for the risk of losses during sudden increases in market volatility, are called volatility risk premium strategies. The volatility risk premium is basically implied volatility (Option’s price) minus realized volatility (Option’s value). These strategies are profitable because implied volatility in options is on average higher than subsequent realized volatility. Numerous papers suggest the possibility to earn a systematic risk premium by selling at-the-money options short-term. This premium is quite substantial – selling put options gives average returns ranging from 0.5% to 1.5% per day. There is a risk premium attached to every single option, option premium run 20% or more per year.

Most researchers speculate that the volatility premium is caused by investors who strongly dislike negative returns and the high volatility on equity indexes and are therefore willing to pay a premium for portfolio insurance offered by puts.

Other researchers explain this effect with the Peso problem (Black Swan event) – a situation when a rare but influential event could have reasonably happened (and removed the premium) but did not happen in the sample; this explanation is, however, highly unlikely as other researchers show that huge market crashes would have to occur every few years to remove the volatility premium altogether.

There is also a possibility to combine volatility risk premium with trend-following; additionally, this anomaly can be observed across all asset classes, for example, volatility risk premium in commodities or volatility risk premium in currencies.

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    The Encyclopedia of Quantitative Trading Strategies

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