Implied Volatility vs Realised Volatility — What the Gap Tells You
Implied volatility is what the market expects to happen. Realised volatility is what actuallyhappened. The gap between them — called the Volatility Risk Premium — is where option sellers and buyers find their edge. Here's how to read, measure, and trade that gap on NIFTY options.
What Is Implied Volatility?
Implied volatility (IV) is the market's forecast of how much the underlying will move over the next period. It is baked into option prices — when you buy a NIFTY call at a given premium, that premium embeds an assumption about future volatility. IV is extracted from option prices using Black-Scholes in reverse: instead of using volatility to price the option, you use the market price to back out the volatility the market is assuming.
Every strike on the option chain has its own IV. In practice, traders focus on ATM IV— the implied volatility of at-the-money options — because ATM options are the most liquid and least affected by skew. When someone says "NIFTY IV is 18," they mean the ATM IV for the nearest expiry is 18%.
Key Insight
What Is Realised Volatility?
Realised volatility (RV) — also called historical or actual volatility — measures how much the underlying actually moved over a past period. It is calculated from the standard deviation of daily log returns, then annualised. If NIFTY moved ±1% per day for the past 30 days, the realised volatility is roughly 16% annualised.
RV is backward-looking. You choose the lookback window: 10-day, 20-day, 30-day, 60-day, or 90-day. Shorter windows are noisier but more responsive to recent moves. Longer windows are smoother but lag behind regime changes. Most NIFTY traders use 30-day RV to compare against IV, because 30 days matches the standard VIX horizon.
| Aspect | Implied Volatility (IV) | Realised Volatility (RV) |
|---|---|---|
| Direction | Forward-looking (expectation) | Backward-looking (history) |
| Source | Option prices via Black-Scholes | Historical price data |
| What it measures | Expected move over next 30 days | Actual move over past N days |
| When it changes | Constantly — shifts with market sentiment | Recalculates daily as new data comes in |
| Typical range (NIFTY) | 12–25% | 10–20% |
The Volatility Risk Premium — Why IV > RV
On average, implied volatility is higher than realised volatility by 2 to 4 percentage points in NIFTY. This gap is called the Volatility Risk Premium (VRP). It exists because option sellers demand compensation for the tail risk they take on — crashes happen, and selling options means you are the insurance provider when they do.
The VRP is not constant. It widens when fear spikes (VIX jumps, IV surges ahead of RV) and narrows during calm markets (IV drifts down toward RV). The average VRP across different VIX regimes:
| VIX Regime | Typical IV | Typical RV | Average VRP | What It Means |
|---|---|---|---|---|
| Calm (VIX < 12) | ~11% | ~9.5% | ~1.5% | Options slightly overpriced — thin edge for sellers |
| Normal (12–16) | ~14.5% | ~12% | ~2.5% | Healthy VRP — steady income for theta sellers |
| Elevated (16–20) | ~18% | ~14% | ~4% | Wide VRP — sellers earn rich premiums |
| High fear (20+) | ~24% | ~17.5% | ~6.5% | Fat VRP — maximum compensation for tail risk |
Key Insight
IV vs RV — How the Gap Moves Over Time
The relationship between IV and RV is not static. IV leads — it reacts to fear and expectation in real time. RV follows — it reflects what actually happened. When a catalyst hits (RBI policy, budget, global sell-off), IV spikes immediately while RV takes days to catch up as the realised moves accumulate. After the event, IV deflates while RV catches up, peaks, and then fades.
Real Example
The Volatility Cone — Is IV Cheap or Expensive?
A volatility cone is a visual tool that shows where current IV sits relative to historical realised volatility at different lookback windows. The cone plots the 25th, 50th, and 75th percentiles of historical RV across 10-day, 20-day, 30-day, 60-day, and 90-day horizons. Current IV is plotted as a single point.
The framework for reading it:
| IV Position | Signal | Action |
|---|---|---|
| Below 25th percentile | IV is cheap relative to history | Buy options — premium understates likely moves |
| Between 25th–75th percentile | IV is fairly priced | No strong vol edge — trade directionally |
| Above 75th percentile | IV is expensive relative to history | Sell options — premium overstates likely moves |
| Above 90th percentile | IV is extremely expensive | Strong sell signal — VRP is likely near peak |
Watch Out
How to Trade the IV-RV Gap
The IV-RV gap creates two primary trading setups — one for option sellers and one for option buyers:
Setup 1: Sell When IV > RV (Positive VRP)
When IV is significantly above recent RV, options are expensive relative to what they deliver. This is the environment for selling premium — credit spreads, iron condors, short strangles. The wider the VRP, the more you earn per unit of risk.
- Best when: VIX above 18, IV above 75th percentile of RV
- Confirmation: VIX peaking and starting to decline (event has passed)
- Avoid when: VIX still rising — VRP can widen further before reverting
Setup 2: Buy When IV < RV (Negative VRP)
When IV is below recent RV, options are cheap — the market is underpricing actual moves. This is the environment for buying premium — straddles, strangles, or directional options. Negative VRP is rare in NIFTY but occurs at VIX bottoms before catalysts.
- Best when: VIX at multi-month lows, IV below 25th percentile of RV
- Confirmation: Known catalyst ahead (RBI, budget, earnings) that could realise higher vol
- Avoid when: Market is calm with no catalyst — IV is low for a reason
| Setup | Condition | Strategy | Edge |
|---|---|---|---|
| Sell vol | IV > 75th percentile of RV | Credit spreads, iron condors | Premium overstates actual moves |
| Buy vol | IV < 25th percentile of RV | Straddles, strangles | Premium understates actual moves |
| Hold | IV between 25th–75th percentile | Directional trades | No strong vol edge — rely on price action |
Four Real NIFTY Examples
Real Example
Real Example
Real Example
Real Example
Common Mistakes
- Confusing IV with RV — IV is the market's forecast; RV is what happened. They measure different things and move independently. Do not assume high IV means high RV will follow.
- Selling options without checking VRP — A VIX of 18 does not automatically mean selling is profitable. Compare IV to recent RV. If RV has been 17%, the VRP is thin and there is no edge.
- Using only VIX for vol assessment — VIX is 30-day ATM IV for NIFTY. It does not tell you about RV, term structure, or skew. Use VIX as a starting point, then compare to RV for the full picture.
- Ignoring lookback window — 10-day RV is noisy; 60-day RV is smooth but slow to react. Match your RV lookback to the IV horizon you are comparing against (30-day IV vs 30-day RV is the standard pair).
- Assuming IV always reverts faster than RV — During crises, both IV and RV can stay elevated. Selling vol at VIX=30 when RV is also 30 means zero VRP — you are just taking risk for no premium advantage. Wait for IV to exceed RV before selling.
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