The Volatility Risk Premium

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. 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. 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 the two—the volatility risk premium is generally considered to be implied volatility minus realized volatility. Volatility risk premium exists in options on every asset class but not in any asset all the time. The volatility risk premium is self-correcting. If it disappears then option buyers will be willing to pay more for options, and option sellers will demand more for options, which will drive option prices higher while having no impact on option values. The way to collect the volatility risk premium is to be short options, but every option seller should use the volatility risk premium sensibly.