Portfolio Timing and Allocation with the Variance Risk Premium

The volatility risk premium (VRP) refers to the systematic difference between implied volatility and subsequent realized volatility. Much of the academic literature focuses on developing strategies to harvest the VRP directly. However, Reference [1] departs from this conventional approach by proposing the use of the VRP as a market-timing mechanism.

Specifically, the author computes the VRP for four major index ETFs—SPY, QQQ, IWM, and DIA—and constructs a composite market-level VRP by averaging the normalized VRPs across these assets, yielding a daily indicator bounded between 0 and 1.

In addition, the author incorporates the VIX/VIX3M ratio as a defensive overlay. Based on these two indicators, market conditions are classified into offensive or defensive regimes, within which asset allocation is determined using 100-day moving averages.

The author pointed out,

The above summary highlights the superiority of VOLTEX-G across key investment metrics compared to the SPY. Specifically, there is a notable increase in annualized return from 14.74% to 17.87%, which is accompanied by a significant reduction in volatility from 17.40% to 12.78%, making VOLTEX-G more stable. Additionally, both the Sharpe Ratio and Sortino Ratio show substantial improvement, indicating a higher quality of risk adjusted returns. The Max Drawdown further confirms these advantages with a reduction from 33.72% to 16.34%, underscoring the strategy’s capital protection capability. Moreover, the significant rise in the Recovery Factor demonstrates SPY’s inability to rebound effectively after major drawdowns. Although improvements in other metrics vary in magnitude sometimes more pronounced and sometimes more moderate, the overall picture clearly reflects the superiority of VOLTEX-G.

In short, the results indicate that using the VRP as a timing indicator improves the portfolio’s risk–adjusted return, while the inclusion of technical filters enhances overall stability.

This represents an innovative application of the VRP that warrants further investigation and experimentation.

Let us know what you think in the comments below.

References

[1] Charalampopoulos, A. (2025). Using Variance Risk Premium to Time a Portfolio of Stock and Bond ETFs. University of Piraeus