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A volatility swap is a financial derivative for speculation on the potential price variations of a security or commodity. This allows for a focus solely on the volatility, the potential changes in price over time, where the value of the underlying asset is not as important. Traders may use a volatility swap for a variety of purposes. They are typically readily available on a trading market for the benefit of investors. Institutional investors tend to trade more frequently in derivatives of this nature.
In this particular financial derivative, traders speculate on how much the price will change and generate a forward contract based on the estimated volatility. This can provide some protection from radically skewing prices, as investors can win whether prices go up or down because of the derivative contract. It is possible to make profits on a volatility swap in addition to the underlying assets. These derivatives can also be used to hedge risk and protect institutional investors.
Traders consider the price history carefully when they construct a volatility swap. They may also look at current and projected performance as well as factors that might have an impact on the behavior of the underlying asset. For instance, if traders are speculating on stock in a technology company, it would be important to know about planned dividends, new product releases, and regulatory changes that might cause stock volatility. It can also help to be aware of market forces that might pressure the company and create falling revenues or other problems that might upset investors and affect the price.
Once traders agree on the terms of the contract, they can finalize the details. It is possible to trade a volatility swap on the secondary market, along with other financial derivatives. This provides flexibility and liquidity as investors move their investments around to suit their needs. Illiquid investments can create disadvantages, especially in a volatile market where prices track up and down rapidly. Investor panic can be a problem in such markets, and may create a ripple effect that makes stocks even more capricious.
The variance swap is a closely related financial product. These focus on the variance, the standard deviation of the price rather than just the volatility. It is possible to make a larger profit from a well-constructed variance swap, which can make it more appealing to derivatives traders. The nature of a financial product should always be clearly distinguished so an investor understands exactly what it involves and can make an informed decision about purchase.