Volatility Premium

Why is there a historical positive spread between implied and realized volatility? There are a number of reasons that the spread between implied and realized volatility exists, but ultimately LJM believes the persistent gap is attributable to behavioral bias of investors. 

If you examine the S&P 500 options market, there is a disproportionate number of natural option buyers relative to option sellers. Because demand is greater than supply, LJM concludes that investors are generally willing to pay a premium to purchase an option, thus transferring the risk of extreme market events to the option seller.

Historically, the forecast for future volatility trends higher than actual volatility the majority of the time, which implies that investors often overestimate the probability of high-risk events. This behavioral bias is often credited with the spread between implied and realized volatility.

Our objective at LJM is to harness the volatility risk premium generated by options to produce returns. LJM relies on sophisticated risk management to balance the amount of risk that we are willing to carry relative to the potential premium. We aim to contain risk during extreme events to create a positive, uncorrelated stream of returns over the long term.

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The strategy can profit in a variety of volatility environments, and especially in markets that are flat or eroding. Our investment management team believes that while every investor is different, our strategy creates a risk/reward profile that can appeal to varied levels of desired risk.