Realized vs Implied Volatility - The Volatility Risk Premium
Reviewed by Leon Moyer - Published October 9, 2026 - Last reviewed October 9, 2026
In this lesson
Compare an option's implied volatility with the volatility the stock later realizes, translate both into dollar moves with the straddle rule of thumb, and explain why the volatility risk premium exists and what selling it risks.
The volatility risk premium is the amount by which an option's implied volatility exceeds the volatility the underlying later realizes over the option's life. On broad stock indexes it has been positive on average: options have tended to price in more movement than the market delivered.
Course 1's What Is Implied Volatility? lesson introduced historical volatility as a backward-looking cousin of implied volatility. This lesson goes one step further. The comparison that settles whether an option was expensive is not implied volatility against the past, but implied volatility against what happens next.
What is realized volatility?
Realized volatility is the annualized standard deviation of a stock's daily returns over a stated period, the same calculation as historical volatility. What matters here is timing:
- Trailing realized volatility (historical volatility) looks back, for example over the past 30 days. You know it today.
- Subsequent realized volatility covers the option's life, from purchase to expiration. You only know it afterward.
When you buy or sell an option you lock in its implied volatility. Whether that was a good price depends on the subsequent realized volatility, which no one knows yet.
How do you compare implied and realized volatility in dollars?
Percentages are abstract. A rule of thumb turns them into dollars: an at-the-money straddle costs about 0.8 x the stock price x implied volatility x the square root of (days / 365).
The 0.8 is not arbitrary. If the stock's return over the period is normally distributed, the average size of its move, ignoring direction, is about 0.8 times one standard deviation (0.798, the square root of 2 divided by pi, which the figures below use). So a straddle's price is roughly the average move the options market expects by expiration.
Worked example
Pricing XYZ's average move at three levels of volatility
XYZ trades at $50. The 30-day 50 call costs $1.81 and the 50 put $1.62 at 30% implied volatility, so the 50 straddle costs $3.43, or $343 per pair.
- One standard deviation at 30%: $50 x 0.30 x the square root of (30 / 365) = about $4.30.
- Average move at 30%: 0.798 x $4.30 = about $3.43. The straddle's price.
Now suppose XYZ goes on to realize different volatility over those 30 days. The average move, per pair of contracts:
- Realized 24%: about $274. Less than the $343 paid.
- Realized 30%: about $343. Roughly break-even on average.
- Realized 36%: about $412. More than the $343 paid.
Illustrative and hypothetical. The ticker and prices are invented for teaching, and the figures exclude commissions, fees, margin interest and taxes, which reduce real results. Past or hypothetical outcomes do not indicate future results.
A straddle's price is the average move it needs
Straddle cost versus the average 30-day move, per contract
The rule of thumb describes averages across many possible paths, not any single outcome. A straddle bought at 30% can still profit when realized volatility is lower, if the one move that matters happens to be large, and it can lose when realized volatility is higher if the stock whips back and forth and ends near $50.
XYZ 50 straddle at 30% implied volatility, at expiration
Hover or tap the chart, or focus it and use the arrow keys, to read any price.
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For the record, the long XYZ 50 straddle above has a maximum loss of $343, if XYZ finishes exactly at $50. Its maximum profit is unlimited above and $4,657 below, if XYZ falls to zero. It breaks even at $46.57 and $53.43 at expiration. Course 3's Long Straddle lesson covers straddles in depth.
Why is implied volatility usually higher than realized?
A 2019 white paper on put-writing by Professor Oleg Bondarenko, summarized by Cboe, found that from 1990 to 2018 the average implied volatility of S&P 500 options, as measured by the Cboe Volatility Index (VIX), was 19.3%, while the S&P 500's average realized volatility was 15.1% (Cboe: White Paper Shows Volatility Risk Premium Facilitated Higher Risk-Adjusted Returns for PUT Index). That 4.2-point gap, over that study's period, is the volatility risk premium. It describes the index: single stocks are noisier, and around earnings their implied volatility can fall short of the move they actually make.
The usual explanation is insurance. Investors pay up for protection against sharp declines, the same demand that creates put skew. Option sellers take the other side, and the premium is their compensation for absorbing losses in crashes, when realized volatility can jump far above anything implied a month earlier.
Is selling volatility free money?
No. An average does not describe the path. The premium is collected in small amounts most of the time and paid back, sometimes all at once, in sharp moves.
Selling a straddle or strangle to collect the premium has undefined risk. The short call's loss is unlimited if the stock rises. On the way down the loss stops at the strike x 100 minus the premium: the short XYZ 50 straddle collects $343 and loses $5,000 - $343 = $4,657 if XYZ falls to zero. Brokers allow uncovered options only in accounts approved for them, and can raise margin or close positions in a sharp move.
- Losses arrive in clusters. The months when realized volatility beats implied are often market shocks, when many short option positions lose together.
- Uncovered options can lose far more than they collect. Course 3's Short Straddle lesson covers those risks in full. Brokers require higher options approval levels for uncovered positions, and FINRA Rule 2360 requires firms that handle uncovered short option writing to keep specific written procedures for it, including procedures for approving those accounts.
- The premium is not guaranteed for any one stock. Trailing realized volatility can understate what is coming, especially before earnings.
Defined-risk structures, such as credit spreads (Course 2's Credit Spreads Explained) and iron condors (Iron Condor Explained), sell volatility with a capped loss. They give up part of the premium for that cap.
How do you measure the gap yourself?
- Note implied volatility at entry for the option you trade, from your broker's chain.
- Compute realized volatility over the option's life after it expires: the standard deviation of daily returns x the square root of 252.
- Record both in your journal with the trade. Over many trades this shows whether you tend to buy options that later prove expensive or cheap.
Check your understanding
A $100 stock's 30-day at-the-money implied volatility is 40%. Roughly what should the 30-day straddle cost?
Show answer
About 0.8 x $100 x 0.40 x the square root of (30 / 365), which is about $9.17 per share, or roughly $917 per straddle.
You bought a straddle at 30% implied volatility and the stock realized 24% over its life. Did you overpay on average?
Show answer
Yes. On average the stock's move was smaller than the move priced into the straddle, so the straddle was expensive relative to what happened, even though any single outcome can differ.
Why does the volatility risk premium exist?
Show answer
Investors pay extra for protection against sharp drops, and option sellers demand compensation for the large losses they take when realized volatility spikes. The premium is payment for bearing that risk.
Key takeaways
- Realized volatility = the standard deviation of daily returns x the square root of 252, measured over a stated period.
- The volatility risk premium is implied volatility minus the volatility later realized; on the S&P 500 it averaged 4.2 points from 1990 to 2018 in a study Cboe summarized.
- An at-the-money straddle costs about 0.8 x stock price x implied volatility x the square root of (days / 365): the average move priced in.
- Sellers earn the premium as compensation for crash risk; uncovered short options can lose far more than they collect.
- Record implied volatility at entry and realized volatility at exit to learn what your own trades paid.
Common questions
What is the volatility risk premium?
It is the gap between the implied volatility options are priced at and the volatility the underlying actually realizes over the option's life. On the S&P 500 it has been positive on average: a study Cboe summarized found an average VIX of 19.3% against 15.1% realized volatility from 1990 to 2018.
Is implied volatility usually higher than realized volatility?
On broad indexes it has been on average, but not every month. Realized volatility can exceed implied volatility for long stretches, and it usually does in a sudden crash. Single stocks vary more, especially around earnings.
What is realized volatility?
Realized volatility is the annualized standard deviation of a stock's daily returns over a given period. Measured over the past, it is the same as historical volatility; measured over an option's life after the fact, it shows how much movement the option actually got.
Can you make money selling options because of the volatility risk premium?
Option sellers collect the premium on average over many trades, but they are paid for taking crash risk, and a single large move can erase many months of gains. Selling uncovered options can also carry losses with no fixed limit. It is compensation for risk, not free money.