Selling volatility can deliver steady income for years and then give much of it back within days. In February 2018, prices of the nearest futures on the Cboe Volatility Index (VIX), a 30-day implied volatility gauge for the S&P 500, roughly doubled within one trading day. Investors holding short-volatility exposure, often through exchange-traded products (ETPs), took very large losses. The episode captures the core trade-off of selling volatility: you collect a steady risk premium in calm periods and absorb severe tail losses when volatility spikes.
Measures of volatility. Two primary measures look in different directions in time. Realized volatility looks back over a past return sample, and implied volatility looks forward from today's option prices.
Historical (realized) volatility. Annualized standard deviation of past returns. The intuition: take daily log returns, square their deviations from the mean, average, and scale to annual. Squaring deviations penalizes outliers and forces every move to count as risk regardless of sign; the factor of 252 converts daily variance to annual because there are roughly 252 trading days in a year.
Common mistakes
- Confusing vega peak and gamma peak. Both peak ATM, but vega peaks for long-dated options while gamma peaks for short-dated. Assigning vega's long-dated peak to gamma overstates the hedging demands of long-dated options.
- Treating implied vol as a forecast of realized vol. Implied vol = expected realized vol + vol risk premium. For equity indices in the Rennison and Pedersen sample, average one-month implied vol exceeded realized by about 2.2 points. Setting expected realized vol equal to implied vol erases the premium that short-vol positions earn.
- Forgetting that short gamma pays the market on every rebalance. In a choppy market, a short straddle loses money on delta-hedging itself even before theta and vega book anything. Counting only theta and vega P&L omits this gamma bleed and overstates the position's profit.
Bottom line
- Vega and gamma both peak ATM: vega for long-dated, gamma for short-dated options. Textbook vega ÷ 100 is per vol point, ÷ 10,000 per basis point; match units in Δp ≈ ν·Δσ.
- Positive vega is not long volatility: a deep ITM index call has positive vega but is short volatility.
- Long vol, correlation-swap buying, and long-index dispersion gain in bad times and tend to carry negative premiums relative to the riskless rate; the short sides tend to earn positive ones.
- Short straddles carry unlimited upside loss; short iron butterflies and condors cap it and are short vol only near the inner strikes.
Exam shortcut
DECISION: Greek questions: ATM + long-dated → vega story. ATM + short-dated → gamma and theta story. Deep OTM/ITM → neither peaks there. Fast lookups: Vega highest? ATM, long-dated. Gamma highest? ATM, short-dated. Vega units? Textbook vega ÷ 100 per vol point, ÷ 10,000 per basis point; Δp ≈ ν·Δσ with matching units. Theta?
The full lesson (about 9,531 words, 64 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- measures volatility
- vega gamma theta
- vol as factor
- modeling vol processes
- implied vol structures
- option strategies vol
- delta neutral vol
- variance vol derivatives
- correlation dispersion
- vol correlation summary
- structured products wrappers
- exotic option features
- global structured cases
- structured product valuation
- currency hedging re
- currency risk perfect markets
- currency risk alts
- futures quanto
- intl re overview
- intl re challenges
- crypto investment styles
- crypto fund strategies
- crypto trading strategies
- crypto risk risk management
- market manipulation cryptocurrencies
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