Shorting Volatility
Profiting from Calm and Managing Risky Storms
Have you ever noticed how people eagerly buy both insurance policies and lottery tickets, year after year spending trillions globally on these seemingly opposite products? While insurance promises peace of mind by protecting against catastrophic losses—a house fire, an earthquake, or a market crash—a lottery ticket represents hope: a chance to gain wildly from a rare upside event. Despite appearing unrelated, both choices reflect the same fundamental transaction: paying to shift risk, either by minimizing unexpected pain or maximizing unexpected joy.
This risk-shifting dynamic is central to financial markets. Whether one seeks to guard against disaster or reach for windfalls, the price for such risk transfer always breaks down into two elements: the expected payout, and a risk premium—extra compensation demanded by the seller to account for uncertain, potentially abrupt outcomes. In options markets, this premium is known as the variance, or volatility risk premium (VRP). The VRP can be accessed through strategies such as selling options (e.g. writing call and put options or structured products like variance swaps) and shorting volatility index futures or exchange-traded products.
Option sellers, like insurance firms, set prices above fair value, anticipating rare but large payouts. Buyers accept this premium to protect themselves, or pursue remote upside—and as research shows, the remoteness of the risk increases the ratio of premium to expected payout. The VRP exists because, historically, the volatility implied by option prices typically exceeds the realized volatility of the underlying asset, creating an enduring profit opportunity for systematic volatility sellers.
Investors routinely pay up for this protection, since markets, much like houses, are more likely to crash downward than surge upward. Selling options—writing volatility insurance—can perform poorly when markets turn turbulent, but this is precisely when demand spikes and the premium rises. Thus, VRP is not a fleeting anomaly, but a persistent reward for providing a risk-transfer service at times when risky assets are performing poorly.
Ultimately, investors pay to hedge against catastrophe; they willingly give up more than fair value to avoid disastrous outcomes, whether that’s a burning house or a collapse in asset prices. There’s a substantial body of empirical research demonstrating that for investors with the discipline and financial stability to weather market cycles, harvesting the volatility risk premium offers a compelling way to earn excess returns by assuming risks that others are desperate to shed.
Empirical Research Findings