VRP either stands for “volatility risk premium” or “variance risk premium” depending on what is being evaluated. Rational insurance buyers know that they overpay for insurance as far as the odds are concerned, but they do it anyway to protect against tail risk that they might not be able to recover from. It is the same with options and why portfolio managers or those with heavily exposed long-only portfolios tend to overpay for deep OTM (out of the money) puts. They are also willing to finance these overpriced long puts with only thin short call premium, which is usually thin because of how many–who are overpaying for tail risk protection–are consciously willing to accept a meager amount from call overwriting so as partially to finance those long puts. 

Expert: Understanding VRP

In general, as Euan Sinclair explains, “The variance premium (also known as the volatility premium) is the tendency for implied volatility to be higher than subsequently realized volatility” (Sinclair, 2020, p. 39). He goes on to claim that [VRP] “is probably the most important factor to be aware of when trading options. Even traders who are not trying to directly monetize the effect need to know of it and understand it. It is the tide that long option positions need to overcome to be profitable” (p. 39). What this means is that VRP is often a hidden element which makes long option premium more expensive than it appears on paper–as compared to projected win rate and max loss/premium. 

What also makes VRP stand out (compared to normal edge) is that this phenomena is generally persistent, which is in contrast to how edges (various forms of competitive trading advantages) are transient, with a finite capacity and brief window of opportunity. “The size and persistence of the variance premium is so strong that the price details of a strategy often aren’t very important. Practically any strategy that sells implied volatility has a significant head start on being profitable if the premium is there” (Sinclair, p. 40). What this tells us is that, without looking, we can generally assume that long options and debit spreads (where the long options have stronger deltas than the short options) carry this penalty as a burden, and so we need to be extra confident about the strength of these trades. 

That said, there are other reasons which relate to why VRP is strong, which still makes long options and debit spreads categorically attractive; namely, how their risk is defined and also how they tend to have a larger max gain than max loss; this dynamic arguably removes the need for a stop loss since there is a logical stop loss built in with the max loss of the debit. Another benefit of debits, especially with uncapped convexity from single-legs or backspreads (more options are long than short), is that they have unbounded opportunity from the jump risk of overnight and weekend gaps—something that option holders gladly pay that extra VRP for. 

On a technical level of timing, there are ways that we can measure VRP, catching it in weak and even inverted states, where the optionality of wide debit spreads becomes relatively much more attractive. The main way to do this is to compare the difference of historical realized volatility and implied volatility: If IV is running cheaper than RV, then this is a sag and technically an inversion of VRP which means that there might be extra edge in going long option premium, all else equal. And in general, skew can be measured, such as how the SDEX tracks the relative cost of OTM puts to ATM puts on SPX about 30 days out.

<Image of VRP analysis from IB’s Trader Workstation>