What it means
Variance Risk Premium (VRP) is the spread between IMPLIED variance (from option prices) and REALIZED variance (from actual underlying price moves over the same period). Historically positive on equity indices (~3-5 vol points on average) — option sellers earn this premium for taking on volatility risk. Compressed VRP (implied vol approaching realized vol) signals complacency; negative VRP (implied vol below realized) is rare and indicates extreme complacency, often preceding vol spikes.
Why it matters
VRP is the structural source of return for option-selling strategies (covered calls, cash-secured puts, vol-selling ETFs like SVXY). Sustained positive VRP is what makes these strategies profitable; VRP collapse destroys them. The 2018 'Volmageddon' was caused by sudden VRP collapse and reversal — vol-selling strategies collapsed in 48 hours.
How to use it
Compare VIX (30-day implied vol) to 30-day realized vol. Positive spread = VRP present; negative = compressed. Use VRP as a filter for vol-selling strategies — only engage when VRP is healthy (>3 vol points). Watch VRP compression as warning signal for vol-spike risk.
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