Volatility Swap

What Is a Volatility Swap?

A volatility swap is a forward-style derivative in which two parties agree today on a strike level of volatility and settle the difference in cash at maturity. The buyer profits if the asset's realized volatility over the contract period ends above the strike, while the seller profits if it ends below. Volatility here means the annualized standard deviation of an asset's price changes, usually measured from daily log returns. Because these contracts trade over the counter, the observation dates, notional amount, and other terms are negotiated between the parties rather than standardized on an exchange.

How It Works

At maturity, the payoff is typically calculated as a notional amount multiplied by the gap between realized and strike volatility:

Payoff = Notional × (Realized Volatility − Strike Volatility)

Some contracts state the notional as a vega amount, which sets how much money changes hands for each point of difference in volatility. The strike is usually set so that the contract has little or no value at the start, so no large upfront payment is typically made. A trader who expects an asset to move more than the market currently prices may buy the swap, while one who expects calmer trading may sell it. Dealers who sell these contracts often hedge their exposure using options and delta hedging, which is one reason volatility swaps are most often used by institutional traders.

Volatility Swap Versus Variance Swap

A closely related product is the variance swap, which pays on realized variance, the square of volatility, rather than on volatility itself. Because variance is not a straight-line function of volatility, the two contracts respond differently to large market moves and are priced differently even at comparable strikes. When strikes are set at similar levels, the volatility swap is generally worth less than the variance swap, a gap linked to convexity. Anyone comparing the two should look closely at how each one behaves in extreme conditions.

Risks and Considerations

• Realized volatility depends on how the asset actually trades, so a calm period can leave the buyer with a loss even if the market seemed uncertain at the start.
• Because the contract is over the counter, each side faces counterparty risk, the chance that the other party cannot make its payment.
• Payoffs can be large in turbulent markets, and the contract's value can change sharply before maturity.