Historical vs Implied Volatility Spread
The difference between implied volatility (the market's forward-looking expectation of price movement embedded in option premiums) and historical (realised) volatility (the actual observed price variation over a recent past period), used to assess whether options are overpriced or underpriced relative to realised risk.
One of the most consequential comparisons an options trader could make was between what the market expected volatility to be (implied volatility, derived from option prices) and what volatility had actually been (historical or realised volatility, computed from recent daily price returns). The spread between the two — often called the volatility risk premium or IV-HV spread — was a key input for strategy selection.
Historical volatility (HV), also called realised volatility, was typically computed as the annualised standard deviation of daily log returns over a chosen lookback period (commonly 10, 20, or 30 days). Implied volatility (IV) was extracted from observed option prices using the Black-Scholes model by solving for the volatility input that made the BSM price equal the market price of the option.
When IV exceeded HV — a positive IV-HV spread — it indicated that options were pricing in more uncertainty than had recently been observed. This could occur for legitimate reasons (an upcoming earnings release, a macro event, elevated India VIX) or as a result of excessive demand for option protection by hedgers. In such environments, option sellers collected more premium than the realised risk might justify, leading to what was termed the volatility risk premium — the systematic tendency for implied volatility to exceed subsequent realised volatility over time.
Conversely, when IV was below HV — a negative IV-HV spread — it suggested that options were underpricing risk relative to recent experience. This scenario was less common but could arise following a period of high volatility that had since abated, where HV still reflected the recent turbulence while IV had already normalised.
In Indian markets, the IV-HV spread on Nifty options was studied extensively by index option traders. Studies of Nifty India VIX versus subsequent Nifty realised volatility showed that India VIX systematically overstated realised volatility on average, confirming the existence of a volatility risk premium in Indian index options. Short volatility strategies on Nifty (selling straddles, iron condors, and credit spreads) derived their edge partially from this structural premium.