Harvesting Volatility Risk Premium with Equity Index Options

The volatility risk premium (VRP) refers to the consistent difference between the implied volatility in option prices and the realized volatility of the underlying asset arising from market participants’ demand for protection against uncertainty. This premium, driven by institutional hedging activity and behavioral biases, offers a systematic opportunity for generating absolute returns. This chapter explains how asset managers can harvest the VRP through strategies that sell options to monetize this discrepancy while managing associated risks. More specifically, it provides an in-depth analysis of a one-month ATM straddle strategy on the S&P 500 Index, where both call and put options are sold to collect premiums, paired with daily delta hedging using futures to minimize directional risk. This strategy is highlighted for its ability to capture the VRP systematically while mitigating the potential for large losses during sharp market moves. The discussion further explores alternative approaches, such as safer structures like iron condors, which add additional out-of-the-money hedges to limit downside risks. The case emphasizes the importance of disciplined risk management in executing VRP-based strategies, addressing challenges such as volatility spikes and market dislocations. Refinements, including more frequent hedging and diversification across strike prices and expiration dates, are suggested to improve performance and reduce exposure to sudden market shocks.