Implied Volatility Is a Forecast. Realised Volatility Is the Receipt.
One is what the market expected. The other is what actually happened. The gap between them is a trade that has paid out for decades.
Two Different Measurements
Realised volatility is arithmetic. Take the daily returns of an asset over a period, compute the standard deviation, annualise it. The answer describes what already happened and is not in dispute.
Implied volatility is the reverse. Take the price an option is trading at, and solve backwards through the pricing model for the volatility input that would produce that price. The answer describes what the market is charging for future movement.
One looks backwards and is a fact. The other looks forwards and is an opinion with money attached.
The Persistent Gap
Across equity indices and over long horizons, implied volatility has averaged above subsequent realised volatility. The market has historically expected more movement than it got.
This is not a market error waiting to be corrected. It is a risk premium. Option sellers are providing insurance, and insurance sells above expected losses or nobody would underwrite it. The buyer is paying for certainty of protection, and that certainty has a price.
The spread between implied and realised volatility is a payment for absorbing tail risk, not a mispricing. Anyone collecting it should understand which side of the insurance contract they are on.
How the Trade Works
A trader who thinks implied volatility is too high sells options and hedges the delta continuously, removing the directional exposure. What remains is a bet that the actual movement will be smaller than the price paid for it.
If the stock moves less than implied, the rebalancing costs less than the premium collected and the position profits. If it moves more, the hedging losses exceed the premium. The trade is a pure comparison of forecast against outcome.
The reverse position exists for anyone who thinks the market is too complacent. Buy options, hedge the delta, and profit if realised movement exceeds what was paid.
Why the Forecast Runs High
Several forces push implied above realised. Demand for protection is structurally one sided, because institutions hedge portfolios and rarely sell insurance on them. Losses hurt more than equivalent gains help, so buyers accept unfavourable pricing. And the memory of past crashes lingers in the pricing longer than it does in the data.
There is also a real hazard being priced. The insurance seller faces losses far larger than the premium collected. Charging above the average expected loss is compensation for that shape, not greed.
Reading the Relationship
The comparison itself is a market signal. Implied far above realised means the market is nervous relative to how things are actually trading. Implied near or below realised means complacency, or that a period of genuine turbulence has begun and expectations have not caught up.
| Condition | Reading | Typical setting |
|---|---|---|
| Implied well above realised | Fear premium elevated | After a shock, before an event |
| Implied near realised | Fairly priced | Trending, uneventful market |
| Implied below realised | Underpricing the present | Turbulence already underway |
Where the Strategy Fails
Selling volatility profits in most months and loses in the rare one. The distribution of outcomes is many small wins against occasional large losses, which is a shape that flatters short track records and disguises the actual exposure.
A strategy that produced steady returns for four years can surrender all of it in a week. That is not the strategy breaking. That is the strategy doing exactly what an insurance business does when the claim finally arrives, and it is the reason the premium existed.
The Bottom Line
Implied volatility is what the market charges for future movement. Realised volatility is what movement actually occurred. The long run gap between them is real and is a payment for bearing tail risk. Collecting it is a legitimate strategy as long as you never confuse a quiet stretch with the absence of the thing you are being paid to absorb.