Shorting Volatility: Harvesting the Risk Premium and Managing Tail Risk

Short volatility strategies, which profit when market volatility remains subdued, have grown popular for their high average returns. They exploit the volatility risk premium (VRP), the persistent gap between implied and realized volatility[1]. Sellers of index options, for instance, historically earned steady profits as at-the-money S&P 500 straddles lost about 3% per week for buyers[2]. Using historical data and recent events, we show that short volatility positions deliver strong risk-adjusted returns—often rivaling or exceeding the equity risk premium—but are vulnerable to rare, extreme losses. One inverse volatility note returned over 1,000% from 2010–2017 (about 40% annually)[3], yet collapsed by more than 90% during the February 2018 “Volmageddon” spike[4]. The VRP has remained positive for decades[5][6], making short volatility an attractive income source. Still, its tail risk can exacerbate financial instability, as seen in 2018 and 2020, highlighting the importance of disciplined risk management for investors and regulators.