Variance Swap

What Is a Variance Swap?

A variance swap is a privately negotiated derivative that lets investors trade the amount an asset's price moves, rather than the direction it moves. At the start, the two parties agree on a fixed level called the variance strike. At expiration, one side pays the other the difference between the realized variance and that strike, multiplied by a notional amount set in advance. Realized variance is usually calculated from the squared logarithmic returns of the underlying price, sampled at regular intervals and annualized.

The payoff can be summarized as:

Payoff = Notional × (Realized Variance − Variance Strike)

How It Works

The buyer of a variance swap profits when the asset moves more than the strike implies, so the buyer is effectively long volatility. The seller profits when price movements stay calmer than expected. No money changes hands when the contract is agreed. The strike is chosen so that the contract has zero value at inception.

Variance swaps are closely linked to options. Because a portfolio of options across a range of strikes can approximately replicate the payoff, the variance strike is often compared with the implied volatility priced into those options. Traders who want exposure to volatility without taking a directional view on the asset may find this relationship useful for understanding how volatility is priced.

Advantages and Risks

Variance swaps can offer pure volatility exposure without the need to continuously adjust positions to remove price direction, a process known as delta hedging. However, because the payoff depends on squared returns, large sudden moves carry heavy weight. A market shock can produce losses much larger than the gains from quiet periods.

Other risks include counterparty risk, since the contract depends on the other party meeting its obligations, and difficulty valuing the contract when markets are illiquid. These swaps are mainly used by institutional traders and dealers. For most individual investors, they are most useful as a reference for how market uncertainty is measured and priced.