CandleFocus Glossary Editor
Variance Swaps are a type of derivative contract that allow parties to exchange payments based on the underlying asset's price changes, or volatility. Each party takes a view on the future level of realized volatility, and will receive payments at the end of the contract period based on whether their prediction was correct.
Directional traders use variance trades to speculate on future levels of volatility for an asset. These traders may take a view that volatility will rise or fall, either because of an expectation of increased market activity or in anticipation of major news events. For example, a trader may expect higher volatility from a major currency pair due to an impending central bank announcement.
Spread traders, on the other hand, might use variance swaps to speculate on the difference between realized volatility and implied volatility in the market. Implied volatility is defined as the expected future range in the price of a security, asset, or commodity. By trading on the difference between implied volatility and realized volatility, spread traders can profit from small discrepancies in either direction.
Finally, hedge traders may use variance swaps to cover short volatility positions. When a trader agrees to sell a call or put option to another trader, they will be exposed to volatility in the underlying asset. Variance swaps can be used to protect against this by locking in a particular amount of volatility and hedging any further move in the market.
Variance swaps are an attractive option for many traders due to their structure, which is based on payments at maturity rather than the marking-to-market of regular options. If realized volatility at the end of the contract period is greater than the agreed strike, then payoffs are positive and all parties benefit from the contract. If, however, realized volatility is less than the strike, then payoffs are negative and all parties suffer a loss. Therefore, variance swaps have become a popular tool for traders to speculate on and hedge volatility risks.
Directional traders use variance trades to speculate on future levels of volatility for an asset. These traders may take a view that volatility will rise or fall, either because of an expectation of increased market activity or in anticipation of major news events. For example, a trader may expect higher volatility from a major currency pair due to an impending central bank announcement.
Spread traders, on the other hand, might use variance swaps to speculate on the difference between realized volatility and implied volatility in the market. Implied volatility is defined as the expected future range in the price of a security, asset, or commodity. By trading on the difference between implied volatility and realized volatility, spread traders can profit from small discrepancies in either direction.
Finally, hedge traders may use variance swaps to cover short volatility positions. When a trader agrees to sell a call or put option to another trader, they will be exposed to volatility in the underlying asset. Variance swaps can be used to protect against this by locking in a particular amount of volatility and hedging any further move in the market.
Variance swaps are an attractive option for many traders due to their structure, which is based on payments at maturity rather than the marking-to-market of regular options. If realized volatility at the end of the contract period is greater than the agreed strike, then payoffs are positive and all parties benefit from the contract. If, however, realized volatility is less than the strike, then payoffs are negative and all parties suffer a loss. Therefore, variance swaps have become a popular tool for traders to speculate on and hedge volatility risks.