It’s important to understand that this should not be interpreted to mean the option market tends to overestimate future volatility. Instead, the more likely explanation is that option prices incorporate a risk, or insurance, premium.
Most investors are risk-averse, so they are willing to pay a premium to hedge downside risk. Buying volatility insurance options provides that hedge or insurance. The large premium also exists because of an imbalance in supply and demand. There are likely far more natural buyers of volatility insurance options than sellers.
The VRP provides another unique source of risk and return that investors can access, one that has the potential to improve the efficiency of diversified portfolios.
Diversifying sources of risk across “factors” (or unique sources of returns) that have demonstrated persistent and pervasive premiums capturable after costs has been shown to be a superior way to improve performance versus the alternative of pursuing the holy grail of alpha, which is becoming a more and more elusive quest as the market becomes more efficient over time.
In terms of VRP strategy implementation, due to its high turnover, it’s important there be a focus on being a patient trader, providing liquidity as opposed to being a buyer of it.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.