Volatility Carry Across Asset Classes

Compare the volatility an option's price implies with the volatility the underlying asset actually delivers over the life of that option, and across equities, currencies, commodities and rates alike, one pattern shows up again and again: implied volatility tends to sit above what actually happens. Sellers of options are, on average, collecting a premium for insurance that turns out to have been priced a bit richer than the risk it covered.

Why implied tends to run above realized

Option buyers are largely paying for insurance against tail events — a market crash, a currency devaluation, a rate shock — and insurance is priced to include a margin above the pure statistical cost of the event, just as credit spreads exceed pure expected loss. Dealers who sell options also need to be compensated for the risk of hedging them imperfectly in a fast-moving, gappy market, which pushes implied volatility higher still. The result is a variance risk premium: on average, selling volatility (through variance swaps, short straddles, or systematically selling options and delta-hedging) has made money, because the insurance was, on average, overpriced relative to what happened.

Scan the implied-volatility surface above across strikes and tenors. The general elevation of implied volatility above what typically realizes is the variance risk premium; the skew across strikes (puts usually priced richer than calls) is the market charging extra for the specific tail event of a crash.

Worked example

A one-month at-the-money option on a stock index is priced off an implied volatility of 18%. Over that month, the index's actual realized volatility, computed from daily closing prices, comes in at 13%. A trader who sold a delta-hedged straddle at the start of the month captured, roughly, the variance gap:

$$18^2 - 13^2 = 324 - 169 = 155$$

That gap in variance units (about 155, or a volatility-equivalent gap of roughly 5 points) translates into P&L on the position through the mechanics of delta-hedging: each day the hedge is rebalanced, the seller profits when the stock moves less than the implied volatility priced in, and loses when it moves more. Over a calm month like this one, the accumulated gains from many quiet days outweigh the cost of the option premium itself, and the strategy nets a profit resembling the variance gap above.

What this means in practice

Systematic short-volatility strategies exist across every major asset class precisely because the variance risk premium shows up broadly, not just in equities — currency options, commodity options and rate caps and floors have all shown a similar pattern historically. Funds running these strategies typically size positions small relative to capital and buy some tail protection specifically because the loss distribution is asymmetric: many small gains, occasionally one loss large enough to erase years of collected premium, as happened to numerous short-volatility products in February 2018.