1125128, 74 PM (2) The Volatty Derivative Markel: Variance Swap Strategies | Linkedln As & BB A. Mev SorBismes™ 08 ebsites The Volatility Derivative Market: Variance Swap Strategies Andrea Lis [3 Senior Global Corporate Execute | Linkedin 8 artcles Tp Voice Quantitative Finance & Economics September 3202 Open immersive Reader) have been getting bombarded with questions from my followers about Variance Swaps. In this article, | will explain this exciting trade, including the strategy involved and how to keep track of your profits or losses. institutional investors often utilize Variance Swaps to take directional bets on implied versus realized volatility for speculative or hedging purposes. A variance swap involves the contract buyer paying the difference between the annualized Fixed Variance Strike, as agreed upon at inception, and the Realized Variance of the underlying asset over the specified period. This payment is applied to a Variance Notional. Unlike Cross-Currency and other Swap variants, a Variance ‘Swap does not involve any cash exchange, either at the start of the swap or during its duration 1nalong variance position, the Payoff at expiry will be positive (negative) if the Realized Variance exceeds (falls below) the swap's variance strike. Should the payment amount be positive (negative), the swap buyer receives payment from the seller (and vice versa). tips: linkedin. com/pulsevolatilty-derivatve-market-variance-swop-srategies-andreaist! wr1125128, 74 PM (2) The Volatty Derivative Markel: Variance Swap Strategies | Linkedln The Payoff at settlement can be calculated using the formula Settlement Amount(T) = Variance Notional * (Realizec variance - Variance Strike) The annualized realized variance is calculated as follows, where Ri = In(Pi+1/Pi) and N is the number of business days observed, which in quantitative finance are 252 days tte Realized Variance = 252 Lw-5 1 the world of market trading, volatility is a crucial factor that most traders consider. When it comes to variance swap trading, there are certain agreements that traders adhere to. For instance, the trade size fora variance swap is expressed ir vega notional. Additionally, the strike (K), which represents the future variance of the underlying, is expressed using volatility, not variance. The Vega Notional, which denotes the average profit and loss of the variance swap for a 1% change in volatility from the strike, is also a crucial consideration. For example, ifthe vega notional is $ 100,000, then the profit or loss for one volatility point of difference between the realized volatility and the strike wil be close to $ 100,000. However, itis essential to note that this is only an approximation because the variance swap payoff is Convex, and the profit and loss are non-linear for changes in the realized volatility, just like many other derivative products Specifically, to calculate the exact Payoff, the variance strike isthe strike squared, and the variance notional is definec and calculated as Vega Notional Variance Notional = 2x Strike Price tips: linkedin com/pulsevolatilty-derivatve-market-variance-swop-srategies-andreais! 21128124, 744 PM (2) The Vola Derivative Market: Variance Swap Strategies | Linkedln After having defined the Variance Notional, I can calculate the Fayoff at time Tas Settlement Amountr = Nyeg Nvartance(0? ~ K?) When calculating the strike on a variance swap, the implied volatility skew for a specific expiration is used. This skew is derived from calls and puts quoted in the market. The volatility skew is essentially a graphical representation of the differences in implied volatilities of a group of options with the same maturity and underlying asset but with different strikes (and thus varying moneyness). Typically, the strike of a variance swap corresponds to the impliec volatility of the put with 90% moneyness, calculated as the option's strike divided by the current level of the underlying For the reader who has never seen a volatility surface, | show below an example of the volatility surface for the S&P 500. Average profile of implied volatility surface foneyness The value of a variance swap at time (t), VarSwap(t), is determined by both the realized volatility from the start of the swap up to t, RealizedVol(0,), and the implied volatility at t,ImpliedVol(t7, for the remaining duration of the swap (7-1), The present value at time (1) of $1 received at maturity T, PVE(N) is also a factor in the calculation. The tips: linkedin.com/pulsevolatilty-derivatve-market-variance-swp-srategies-andreais!1125128, 74 PM (2) The Volatty Derivative Marke: Variance Swap Strategies | Linkedln formula for the valuation of a variance swap at time (t is as follows: Verswape = Valance Notional x PHT) x [Ex RealzedVol 0.0) Lumpliavot ery} strike?) tis worth noting that the sensitivity of a variance swap to changes in implied volatility reduces over time. One of the critical aspects that makes variance swaps appealing to investors is that their payoffs are convex in volatility. This is because being long a variance swap is similar to a long basket of options and shorting the underlying asset (usually by selling a futures contract). A long position in a variance swap is thus long gamma and exhibits a convex payoff. This feature enables volatility sellers to sell variance swaps at a higher price than at-the-money options, as the sway convex payoff profile is attractive to investors who desire a ‘ong volatility position as a tail risk hedge Practical Example: will now provide an example of a Variance Swap Trade, and | will both calculate the Payoff at Expiration and how to Mark-to-Market my position five months after inception. Let's assume that | am a volatility speculator who sells volatility on the stock price of Company ESAB (ticker ESAB). want to sell a $200,000 Vega Notional of a one-year swap on ESAB at a strike price of 30% (quoted as annualized volatility). Taking the short side of the trade, my bet is that, the one-year implied volatility quoted in the options market, is too high, and the realized volatility at expiration will be below 30%. Let's assume that | want to Mark-to-Market my positior after five months and that the interest-free interest rate is 3%, the realized volatility from t=0 to t=five months = 25%, and the Implied Volatility of Esab for the next seven months is 22%, Using the VarSwap(t) formula presented above, the value of my position will be calculated as follows. tips: linkedin. com/pulsevolatilty-derivatve-market-variance-swop-srategies-andreaist! an1125128, 74 PM (2) The Volatty Derivative Markel: Variance Swap Strategies | Linkedln ® sm BR fpgeminl gaat me) © nom dimes , ga Taw p00 Ory 4 4 et ofgx? 42a - so asatns Ya, 39 « 0. x 959 AAAs Source: Andes Lisi in this case, because | hold the short position in the trade, my position will be positive by $ 1.169 Million Let's assume now that one year has passed, and | want to calculate the payoff of the swap at expiration. | assume that my prediction was right, and the realized volatility on ESAB has been 20%. Applying the Settlement Amount formula, my payoff will be: Payor fr = Variance Notional x (Realized Variance ~ Variance Strike) $200,000 2 _ ap2 = SRE (20? 308) = $1,666.67 Source: Andes Lisi f the amount is negative, the swap buyer will pay the swap seller $ 1,666,667. Report this Published by Anda isi ve Unt top Vie Quanta Farce & tips: linkedin com/pulsevolatilty-derivatve-market-variance-swop-srategies-andreais!1125128, 74 PM (2) The Volatty Derivative Markel: Variance Swap Strategies | Linkedln @ bed Ao 8 articles am always bombarded with questions abou volatility trading My flowers are ‘often cious about how to buy and sel volt inthe market. Wel, today your lucky day! nti ate share with you my knowledge on how o use a Voality ‘Shap, one ofthe mest popula derivate instruments inthe market lao tack you how to calculate its market valve throughout isle and how to alu its payoff epraton, There are two types of vlatltytradesin the market Qvoltity speculators @ Volalty hedgers The formes, consisting of hedge funds and instuonal investors ae typically short vol Why? Because the majority of options expire out ofthe money, which means they get to pocket the option premium. On the ther hand, velaity hedges are net lng vl and are many intersted in protecting ther potolio against a sudden spike in voatity So, whether you're = ‘alatltyspeclator or volatility hedge youl id ths article to be jam-packee vith useful information that will help you navigate the complex world of vat trading Get ready to take your trading game tothe nest level Please eel fe to comment. ays value the opinions of my flowers. volatlitrading Rderivatives “options #zourcing investing #hedgetunds Linkedn Bloomberg Ainsttuonalivestors portoiomanagamentastockmarket FOGG EGER Site Deonment shaw gutaeaena 5 Comments Most elevare™ @ ret aie ‘Adam Feacock ids amo Flies eso rads, Cua ‘Andes Us Labor Day Weekend = theta? ke 0 2 | Reply 1 Repy Anda Lisi ie/Hin) BB +26 anow Faunce & Economics, a ‘Adam Peacockthats a good one Buy put so you wil be long theta he | ep Sathish Ramesh, MBA «3s sine Faleaerin Pat faut bated companies with fia Manclactsng tat Become ‘andrea Lis Fantastic explanation, Thankyou! he 1 | Rey «1 Rely @ retest erin {ovr Gl Coprte ese| ned op oe Que Satish Ramesh, MBA am gl of your postive feedback she | Reply Lead mare comments Andrea Lis [3 tips: linkedin.com/pulsevolatilty-derivatve-market-variance-swp-srategies-andreais!1125128, 74 PM (2) The Volatty Derivative Marke: Variance Swap Strategies | Linkedln ce Quantatve Finance & Senior Global Corporate Executive Linkedin Top (GF retiow More from Andrea Lisi & How fo use Beta to assess, i Investor Financ your Potfoli Risk Wallnes: An effective Decumulaton Strategy. dea Us on Linked ‘dre lis on Linkedin How can blocchain technology improwe your comanys productiviy? ‘dre lis on Linkedin Seo a8 articles tips: linkedin. com/pulsevolatilty-derivatve-market-variance-swop-srategies-andreaist! m7