What is the essence of IV and RV in options trading?

IV and RV are equivalent to stock price and company value, futures price and spot price, Treasury bond yield and corporate bond yield...

Economy (or trade) is based on barter, and finance derived from economics also follows this oldest setting. Compared with the absolute price value, the relative price deviation is important.

For example, the deviation of a stock's price from its intrinsic value (if any).

For example, the difference between the futures price and its corresponding spot price is called the basis.

For example, the premium of corporate bonds relative to government bonds is called the credit risk premium.

So does implied volatility have the same "premium" as the price of options? Of course there is. If the underlying volatility RV linked to the option is taken as the "intrinsic value" of the option, then the difference between the implied volatility and the underlying volatility is the "basis" of volatility - the basis of volatility risk. Volatility risk premium, referred to as VRP.

IV = RV + VRP

That is, for the option buyer (IV long), the cost can be decomposed into two parts: the first part is the "intrinsic value" of the option, RV, and the other part is the basis change in volatility, VRP premium.

So what is the use of this VRP?

A positive VRP means that being an option seller and hedging will (at least initially) guarantee a positive (expected) return.

So, how to understand this positive VRP?

If you think of the options market as an insurance market for the underlying, the option buyer is the person who buys insurance for the underlying. The seller of an option is the person who provides the bottom line for the underlying asset. So since I want to help you with the bottom line, you can't just set a BS price and sell it to the buyer. This is too unkind to the person who will take the bottom line for you when the target explodes.

Therefore, this VRP can be understood as: a part of the risk premium required by the option seller in order to provide insurance for the option buyer. Furthermore, the existence of (positive) VRP is the key for option sellers on the market to maintain a high winning rate.

AQR has done some research on VRP in the U.S. options market. One of the papers studied the relationship between VRP in the U.S. options market and the winning rate of option sellers. The conclusion is roughly as follows:

1. From 1996 to 2016, VRP was greater than zero 88% of the time. In other words, option sellers in the U.S. market had positive VRP as premium protection 88% of the time.

2. On average, the average VRP is about 3%. That is, option buyers in the U.S. market have to pay a 3% purchase price as soon as they enter the market to buy options.

These two points explain why option sellers can maintain a very high winning rate for a long time.

There is also a paper that studies whether it is more cost-effective to buy put for asset protection in an extremely calm market.

The answer is: no. Because even when the volatility of the SP500 was at its lowest (annualized at 5.3%), the VIX of U.S. stocks at that time was 11.6%. In other words, even if you buy a bearish underlying for protection when the volatility of U.S. stocks is at its lowest, you will still There is a VRP premium of up to 6%.