Volatility Swap

A volatility swap is a swap contract where one party bets that realized volatility will exceed a predetermined strike (the swap rate), while the other party takes the opposite side. Unlike options, which have optionality (the right but not obligation), volatility swaps create symmetric payoffs: both parties have obligations based on how realized volatility compares to the strike. Volatility swaps are used by traders to express pure volatility views independent of direction.

How volatility swaps work

A trader believes implied volatility at 20% is too low; realized volatility will exceed 25%. The trader enters a 1-year volatility swap with a counterparty:

Terms:

• Notional: $100,000
• Strike volatility: 20%
• Realized volatility (measured at expiration): X%

Payoff at maturity: If realized volatility is 28%:

• Payoff = $100,000 × (28% − 20%) = $800,000

If realized volatility is 18%:

• Payoff = $100,000 × (18% − 20%) = −$200,000

The trader gains if realized > strike; loses if realized < strike.

Realized vs. implied volatility

Implied volatility is the market’s forecast of future volatility at option initiation.

Realized volatility is what actually occurs over the contract’s life.

Volatility swaps bet on the gap: if you believe the market overestimates future volatility, you sell realized volatility (bet it will be lower than implied).

Advantages vs. options

Options are complex: they have delta, gamma, theta, vega. Volatility swaps are pure volatility bets with no directional exposure and no time decay.

Buying a volatility swap (long realized vol) is simpler than buying a straddle (buy call and put), which also has gamma and theta complications.

Strike determination

The strike is typically set at the implied volatility at initiation (par value = 0 to both parties). But strikes can be negotiated; a trader might buy realized vol at a strike of 18% (lower than the current implied of 20%), accepting less upside for protection if realized vol falls.

Variance swaps

Related but distinct are variance swaps, which pay on the square of volatility (variance). Variance swaps have different convexity than volatility swaps and are more sensitive to extreme moves.

Use cases

Hedging: A portfolio manager long volatility exposure (short gamma) can hedge via long realized volatility swap.

Speculation: A trader bullish on volatility buys realized vol to profit if volatility spikes.

Relative value: Buy realized vol at 20 strike, sell another volatility swap at 25 strike, betting realized vol will settle between them.

Counterparty risk

Volatility swaps are OTC contracts with counterparty risk. The seller must pay if realized volatility exceeds the strike by a large amount. Some swaps require collateral or are cleared.

See also