What are Volatility Derivatives?

Volatility derivatives are financial products where the volatility of an underlying asset is the tradable product. Volatility is the rate of price change in an underlying asset, such as a financial index. Standard deviation is a measurement of volatility. A derivative is a financial contract. The price of the contract is derived from an underlying asset.

The payoff of volatility derivatives depends on the realized volatility of an underlying asset. A common example of trading volatility might be speculation of the future uncertainty of a major stock index. Volatility rises when uncertainty increases, and it reverts to a normal range when uncertainty decreases. Volatility tends to remain high as the price of an asset falls. Falling prices tend to indicate rising volatility.

Many volatility derivatives are exchange traded. Volatility-based products are available on indexes and currencies. Retail volatility trading is relatively new, but institutional volatility derivatives have been around for several years. Volatility products are available in the form of futures, options and exchange traded funds.

Over-the-counter (OTC) financial derivatives are also available for trading volatility. Variance swaps on indexes and individual stocks are known as variance derivatives. These products might not be available to the retail trader.

Trading the spread between implied and realized volatility is another type of volatility trading. Historical volatility and implied volatility can be charted. Technical analysis techniques can be used to predict the future realized volatility. This type of trading is referred to as spread betting.

The purest way to trade volatility is through a volatility swap. This is a forward contract on the realized volatility of an underlying asset. Volatility swaps are commonly traded on currencies. Variance swaps are more commonly used for equities. Variance swaps have a higher payout because variance is calculated as the square of standard deviation. Variance swaps can be used to hedge volatility exposure.

Volatility derivative trades can be constructed through the use of delta hedging vanilla options. Various combinations of delta trades can accomplish a volatility trade. The parameters of the trade are determined by the option Greeks. The Greeks measure option sensitivity to movements in the underlying asset. This type of volatility trading might not be cost effective.

Investing in volatility derivatives requires a comprehensive knowledge of options and other derivatives. The fundamental concept of volatility, implied volatility and forward volatility must be fully understood before one trades these highly complex derivatives. Educational resources are available online and through derivatives brokers.