Volatility risk premium (VRP)

Options almost always price in more volatility than the market ends up delivering. Implied volatility exceeds realized volatility in a large majority of months, and that persistent gap is the volatility risk premium (VRP). Sell volatility (options, variance swaps, a strip of straddles) and over time you're paid to be short that gap.

The premium exists because option buyers aren't only forecasting variance. They're buying insurance against a crash. Most months nothing crashes, the insurance goes unused, and the seller pockets the difference between what was priced in and what actually happened. It's compensation for carrying a risk almost no one wants to hold outright.

Measured against realized volatility over matching maturities, harvesting VRP produces a steady-looking return stream: a modest Sharpe ratio, positive most months, nothing that jumps off the page.

That's exactly the problem. Sharpe collapses a distribution into one number, and this distribution isn't symmetric. VRP strategies carry severe negative skew — small, frequent gains funding one infrequent, large loss when a real shock arrives and realized volatility jumps past implied. The Sharpe ratio computed over a calm stretch describes the frequent part of that distribution and stays silent about the tail. A flattering number and a fat tail sit in the same trade.

This is the clean case for conditioning on market state instead of direction. VRP is never a bet on where price goes. It's a bet on the size of the move — the second moment — and direction never enters the calculation. Tools built to read that dimension, like dealer gamma and the positioning it implies, exist to gauge whether the market is primed to stay calm or primed to gap.

We treat any VRP harvest the way we treat any smooth equity curve: with the assumption that the sample hasn't seen its crash yet, and that the real cost of the trade shows up exactly once, late, and all at once.