The cost of acquiring wealth in the financial markets

Written by: Adam

Edited by: AididiaoJP, Foresight News

On social media, you often see this phenomenon: people chase and even praise various unique metrics, strategies, and charts, talk about “advantages,” and share “wealth secrets.”

Let me pour cold water on that: while advantages and alpha do exist, what you often see on YouTube or Twitter has nothing to do with them.

Most of the strategies displayed online are not alpha. They are more fundamental but completely overlooked by most people, who don’t even understand why they work.

Most people think that to make money in trading, you need to be smarter than the market. But in reality, you only need to be willing to take on risks that make others uncomfortable.

This is risk premium. Once you understand it, you can not only see why you are making money but also build strategies logically and stick with them long-term.

What is risk premium?

Before talking about trading, let me illustrate with a simpler example.

Insurance companies are profitable businesses. You buy fire insurance for your $200,000 house, paying about $300 annually.

Insurance companies have actuarial tables—they know your house has roughly a 1 in 5,000 chance of catching fire.

This means their expected annual payout per policy is about $40.

So, they collect $300, expect to pay $40, and earn a profit of $260.

But the key point is: you also know these probabilities. Neither side has secret information about fire risk. Both understand the math. So why are you still willing to pay?

Because you are transferring risk. You prefer to pay a certain $300 rather than face the tiny chance of losing $200,000.

To get rid of this uncertainty and anxiety, you are willing to pay $260 annually.

The insurance company takes on your anxiety and gets paid for it.

That $260 is the risk premium.

Its existence is not due to information asymmetry or skill but because bearing risk itself is uncomfortable, and someone needs to be compensated for it.

Stock Price Appreciation

The simplest, perhaps most “primitive,” risk premium is the equity risk premium. Let’s talk about stocks, because some people still have misconceptions about it.

There is a strange view that stocks “should” return 7-10% annually, as if this is a physical law, and the market owes you a fee for exiting.

But that’s not the case.

The long-term upward trend of stocks is actually a form of compensation.

If you buy and hold SPY (S&P 500 ETF), you embark on a journey. Your portfolio might be halved during a crisis, or go sideways for ten years (like from 2000 to 2010), and individual companies can go bankrupt.

Recessions happen, wars happen. Sometimes it feels terrible; after checking your account, you might even curl up under a cold shower and cry.

This is precisely why the premium exists.

If holding stocks felt very safe, their returns would be similar to short-term government bonds.

If META (Meta Platforms stock) had volatility and drawdowns like bonds, everyone would buy it.

But that’s not the case. Despite rising countless times since 2013, it also pulled back 40% last year and 80% in 2021.

So who would accept the risk of stocks for the same return as risk-free government bonds?

No one.

Stock investors demand extra compensation for this uncertainty. Historically, it’s about 4-6% above the risk-free rate annually.

Interestingly, despite everyone knowing this, the equity risk premium has not disappeared.

Data from over a century, across dozens of countries, through world wars, the Great Depression, and technological revolutions, all confirm this.

The premium persists because the underlying risk remains. Someone must hold stocks, and those who do want compensation for this “discomfort.”

This is fundamentally different from trading advantages: once discovered, they are arbitraged away. But risk does not disappear just because you understand it.

Bitcoin: Risk premium or something else?

This brings us to Bitcoin, an interesting case.

Since its inception, BTC has shown an extremely strong price trend.

Far above stocks. If you buy and hold throughout, despite severe drawdowns, the returns are astonishing.

The honest question is: is this really a risk premium, or something entirely different?

I believe there is no definitive answer yet.

For stocks, we have over 100 years of data across multiple countries and economic systems.

This is enough to be quite confident that the premium is structural.

But for Bitcoin, we only have about 15 years of data, as a single asset, in a specific technological and monetary environment. And since the COVID-19 pandemic, Bitcoin has undergone huge changes: funds now come from ETFs, options markets are extremely active, and so on.

The long-term upward trend in price might be a form of risk premium.

Holding something that has crashed 80% multiple times is indeed very uncomfortable. If the asset continues to appreciate, part of its return is likely compensation for enduring such volatility.

But it could also be early adopter effects, speculative momentum, or just a bubble that hasn’t fully burst. Most likely, it’s a combination.

What I want to say is: the speculative component in crypto markets is higher than in traditional markets. This isn’t necessarily bad, but it also means your future returns are more uncertain.

Anyone claiming to know that BTC will return X% annually is extrapolating from very limited data, honestly facing what they don’t know.

As for altcoins, we need not say much—they mostly perform poorly and are suitable only for short-term speculation.

Arbitrage Premium: Traditional vs. Modern

Let me explain arbitrage trades, because they are very typical examples of risk premiums, existing in both traditional finance and crypto.

Classic arbitrage operates in the forex market.

You borrow a low-interest-rate currency (like JPY, with 0.5% interest) and invest in a high-interest-rate currency (like AUD, with 5%). You earn the 4.5% interest spread. This is forex arbitrage, which has historically been profitable.

Why is it effective? Because you are taking on risk.

When global risk appetite collapses, high-yield currencies often plummet, while safe-haven currencies like JPY and CHF appreciate.

In the chaos of a few days, you could wipe out all your accumulated arbitrage profits. The stable income is compensation for bearing this occasional, severe reversal risk.

In futures markets, the same concept is implemented via basis trading.

When futures prices are above spot prices (futures premium), you can buy the spot and short the futures, locking in the spread as profit.

This is called cash-and-carry arbitrage.

Traditional futures like government bonds or stock indices often have basis opportunities that professional traders exploit.

But in reality: in traditional markets, these opportunities are almost zero for retail traders.

Hedge funds use repo financing, leverage 30-50x, to trade bond basis, earning tiny spreads that only large-scale operations can profit from.

The big players have already cleaned out these markets.

Crypto markets are different—at least for now.

Perpetual contract funding rates are basically crypto’s version of arbitrage.

When funding rates are positive (which they usually are, because most retail traders are long and exchanges charge longs), longs pay shorts every 8 hours.

So you can do this: go long spot BTC while shorting perpetual contracts, remaining market-neutral (delta-neutral), and earn the funding rate.

Why do positive funding rates persist? Because retail traders want leverage long positions.

They are willing to pay for it. Market makers and arbitrageurs stand opposite, providing the liquidity retail needs, and earn the funding rate.

The risk points are similar to forex arbitrage.

During a crash, funding rates can turn sharply negative, which is exactly when your risk exposure is greatest.

The Bank for International Settlements’ research also points this out: crypto arbitrage strategies can suffer severe drawdowns, with frequent liquidations during volatile periods.

Most of the time, you earn stable small profits, only to give back months of gains in a single event. This is similar to selling insurance with a negative skewed return profile.

Funding rate premiums still exist, although in large-cap coins they are less obvious and less profitable than years ago. Altcoins often show extremely high funding rates, especially on platforms outside major centralized exchanges.

But this adds another risk: counterparty risk, because smaller, often decentralized exchanges are more vulnerable to hacking or insolvency.

Volatility Risk Premium

If there is a risk premium that is well-documented and easy to trade, it’s the volatility risk premium.

In S&P 500 options, and most ETFs, stocks, futures, implied volatility is about 85% of the time higher than subsequent realized volatility.

This gap exists because investors systematically pay too much for hedging.

Institutions hedge portfolios.

Retail investors buy puts out of fear.

All these demands push option prices above fair value.

The volatility risk premium is the compensation for selling this insurance.

That’s why selling options is usually more sensible than buying.

Selling straddles, wide spreads, or covered calls—these strategies all harvest the same underlying premium.

The problem is the return profile: you make steady money most of the time, but lose big during crashes.

Selling puts during the COVID-19 March 2020 or the 2008 financial crisis was devastating.

That’s why I’m not a big fan of “income strategies”: selling options on a basket of stocks, which often get hit hardest during crashes.

But overall, this risk profile is not a flaw in the strategy. It’s the reason the premium exists.

The chart below shows the returns from selling 30-day at-the-money straddles on SPY: lots of steady income, often wiped out by extreme volatility events.

If doing this feels comfortable, everyone would do it, and the premium would disappear.

You can see similar dynamics in skewness—another form of harvesting risk premium.

From the 25-Delta skew chart, it’s clear that on SPY, the implied volatility of 25-Delta puts is always higher than calls.

Out-of-the-money puts are “more expensive” than at-the-money options and calls.

The volatility smile tilts because everyone wants downside protection.

Selling put spreads or risk reversals can harvest this skew premium. The return profile is the same: steady income, with occasional large losses.

SPY spot price - implied volatility correlation: when prices fall, implied volatility rises.

This is due to the common “staircase up, elevator down” pattern: crashes tend to be more violent than slow rises.

Momentum Premium: the positive skew

Most risk premiums have a negative skew: small gains most of the time, occasional huge losses. Momentum is different.

Historically, assets that have been rising tend to keep rising; those that have been falling tend to keep falling.

This trend-following premium is documented across stocks, bonds, commodities, and currencies over long periods.

The explanation is mostly behavioral:

Investors initially underreact to news, creating persistent trends; or there’s herding, attracting more buyers and pushing prices further in the same direction.

The interesting thing about momentum is its return profile:

In choppy, non-trending markets, you lose small amounts. Signals repeat, stop-losses are hit, and trading costs eat into profits.

But when a big trend develops, you can earn huge gains.

This is positive skewness, the mirror image of short volatility strategies.

That’s why momentum strategies tend to perform well during crises. When markets crash, trend followers short and trend downward. When volatility sellers are crushed, trend followers often remain unscathed.

The bad news is: momentum has weakened over the past decades. More capital now chases these signals. When an advantage is widely known, competition erodes returns.

The premium has not disappeared entirely, but its magnitude is lower than what historical backtests suggest.

Recent commodity trends exemplify this: months or years of sideways movement and small returns, ultimately offset by a big move.

Mean reversion?

When market positioning becomes extremely skewed, mean reversion often kicks in. This applies to both crypto and traditional markets.

In crypto, you can observe this through funding rates and open interest. When funding is deeply negative, futures are far below spot, everyone is extremely short, and no one wants to buy, it looks terrible—and that’s exactly why everyone is so short. Contrarian long positions tend to be profitable on average.

Why is this risk premium and not just a pattern? Because at times of greatest market uncertainty, you are on the opposite side of crowded trades.

Everyone shorting makes sense: bad news, uncomfortable to buy.

You are doing something useful: providing liquidity when no one wants to, and earning the expected profit as your reward.

The same logic applies to forced liquidation cascades. When longs are liquidated, they sell involuntarily, pushing prices below fair value. The other side is the same.

Intervening to buy in that chaos requires conviction and exposes you to real risk. The expected profit from mean reversion is the reward for providing this “service.”

Similar dynamics exist in traditional markets.

Due to storage and financing costs, futures term structures are usually in contango.

But occasionally, during supply shortages or panic, they flip into severe spot discounts (backwardation). Spot premiums tend to revert to futures premiums over time, as the latter is the equilibrium.

If you bet on the reversion by going long futures during extreme spot discounts, you are betting on normalization. History shows this is often effective.

But the real risk: the time in which the term structure remains inverted can be longer than your ability to survive. If a true supply crisis occurs, spot premiums may intensify before reverting. You are compensated for this risk, but you can also be crushed by the market.

Institutional-level risk premiums

The above are at least somewhat accessible to retail traders.

But some risk premiums mainly exist in institutional markets, even if you cannot trade them directly, it’s worth understanding.

Bond term premium: When you buy a 10-year government bond instead of rolling over 3-month T-bills for 10 years, you bear duration risk from interest rate changes. The term premium is the extra yield you earn for taking this risk. This premium fluctuates greatly; during QE, it was sometimes negative (investors paid for holding long-term bonds), and after 2022, as interest rate uncertainty increased, it turned positive again. This is more background knowledge for retail investors but relevant for your bond allocation decisions.

Credit risk premium: Corporate bonds yield more than comparable government bonds; the spread compensates for default risk. This premium widens sharply during crises (like 2008), providing huge returns for investors who bought then. But the risk is: defaults tend to happen during recessions, stock market drops, when you least want losses.

Liquidity premium: Less liquid assets (like private equity, real estate, small caps) offer higher returns because you give up the convenience of “being able to exit anytime.” The challenge: liquidity often dries up precisely when you need it most (during crises). The premium is compensation for this risk.

Key distinction: Risk premium vs. Alpha

I see people sharing “alpha” every day on X, usually some technical indicator or lines on a chart. That’s clearly not alpha.

Alpha: excess returns derived from skill or informational advantage. Once discovered, it gets copied and diminishes. Limited capacity, temporary.

Risk premium: compensation for bearing systematic risk. Even if widely known, it persists because the underlying need to transfer risk doesn’t vanish. High capacity, persistent.

Practical test:

If your strategy works because you are smarter than others, that’s alpha.

If your strategy works because you’re willing to do uncomfortable things others avoid, that’s risk premium.

Insurance companies earn risk premiums. It’s well known, but they still make money because someone has to bear the risk.

Blackjack card counters earn alpha. Once the casino finds out, they get banned, and the advantage disappears.

Most retail traders should focus on understanding which risk premiums they are exposed to, rather than chasing alpha. Premiums are more reliable and less likely to vanish; alpha is highly competitive and very hard to achieve.

Recognizing that you might not be smart enough to compete in that space, though uncomfortable, is beneficial in the long run.

Why most premiums are negatively skewed

This is often overlooked: almost every risk premium has a negative skew.

Frequent small gains, occasional huge losses.

This is not a design flaw; it’s the reason premiums exist.

If harvesting premiums always felt good, everyone would do it, and premiums would vanish.

Those occasional huge losses are the threshold that keeps most people out, reserving profits for those willing to accept the risk.

Stock risk premium: most years, steady gains, then a 30-50% crash.

Volatility risk premium: monthly premiums collected, then wiped out in a week.

Arbitrage premium: steady profit from spreads, then wiped out during risk-off events.

Credit risk premium: steady interest income, then losses during recessions.

Understanding this pattern is crucial for position management.

The expected value of premiums may be positive, but you must survive the drawdowns to realize it. Overleveraging destroys you before the long-term benefits arrive.

Diversifying across premiums with different skewness helps smooth returns. For example, combining short volatility (negative skew) with momentum strategies (positive skew) can improve overall performance.

Building a portfolio of multiple premiums rather than concentrating on one is usually wiser.

Correlation is critical: if you short VIX futures for carry, while long 10 different S&P 500 stocks, a 5% market drop tomorrow could wipe you out.

What does this mean for practice?

Risk premiums are earned by doing what others are unwilling to do: holding uncertainty.

Long-term stock market growth requires someone to bear the downside risk.

Implied volatility exceeds realized volatility because someone must sell insurance.

Positive funding rates exist because someone needs to provide leverage.

Persistent market trends exist because others are systematically buying when you try to short.

Extreme positioning will revert because, when liquidity dries up, someone must step in.

Even if widely known, these returns still exist. They are more reliable than alpha—once alpha is discovered, it diminishes.

The cost is in the return profile: you are rewarded for enduring occasional huge losses.

Set your position sizes wisely. Diversify across different premiums. Accept that premiums exist precisely because they sometimes feel terrible.

You don’t have to be the smartest in the market.

Sometimes, just being willing to take on risks that make others uncomfortable is enough.