A Volatility Swap is a forward contract whose underlying is the volatility of a given product. This is a pure volatility instrument allowing investors to speculate solely upon the movement of a stock’s volatility without the influence of its price. Thus, just like investors trying to speculate on the prices of stocks, by using this instrument investors are able to speculate on how volatile the stock will be.
In other words, a volatility swap is a forward contract on the future realised volatility of a given underlying asset. Volatility swaps allow investors to trade the volatility of an asset directly, much as they would trade a price index.
The underlying is usually a foreign exchange rate but could be as well a single name equity or index. However, the variance swap is preferred in the equity market due to the fact it can be replicated with a linear combination of options and a dynamic position in futures.
Unlike a stock option, whose volatility exposure is contaminated by its stock price dependence, these swaps provide pure exposure to volatility alone. You can use these instruments to speculate on future volatility levels, to trade the spread between realized and implied volatility, or to hedge the volatility exposure of other positions or businesses.
Volatility for market players
When investing directly in a security, volatility is often viewed as a negative in that it represents uncertainty and risk. However, with other investing strategies, volatility is often desirable. For example, if an investor is short on the peaks, and long on the lows of a security, the profit will be greatest when volatility is highest.
In today’s markets, it is also possible to trade volatility directly, through the use of derivative securities such as options and variance swaps.
Formula:
The annualized volatility σ is the standard deviation σ of the instrument’s logarithmic returns in a year.
The generalized volatility σT for time horizon T in years is expressed as:
