How it works
Historical (realised) volatility is computed from past returns: take the standard deviation of daily log returns, multiply by the square root of 252 to annualise. Implied volatility is solved backward from option prices: given strike, expiry, and underlying, what volatility input makes the model output match the market option price. The two often diverge, and the gap is itself a tradable signal.
Example
S&P 500 30-day realised volatility might be 12 percent annualised in a calm market. The VIX (30-day implied volatility) might be 15 percent at the same moment. The 3 percent gap is the volatility risk premium that option sellers earn on average. In a crisis, realised can spike to 60 percent while VIX hits 80 percent. The signs flip too: in 2020 the VIX exceeded 80 in days.
Why it matters
Volatility drives position sizing, option pricing, and strategy fit. A strategy designed for 15 percent volatility breaks when volatility doubles. Risk-budget your positions in volatility units (sigma) instead of dollar units to maintain consistent risk across regimes. Use the realised-implied gap as a market sentiment signal: high implied with low realised often precedes calm; high realised with low implied warns of underpricing.
