A variance swap is a forward contract on realised variance. At maturity, one side pays the realised variance of the underlying over the period and the other pays a strike fixed at inception. It gives pure exposure to volatility, without the delta hedging an option position requires.
How it works
Payoff = variance notional × (realised volatility² − strike²), with volatilities in points. By convention the trade is sized in vega notional, the P&L for a one-point move around the strike, and variance notional = vega notional / (2 × strike). Realised variance uses daily log returns, usually with a zero mean, annualised over 252 days. The fair strike comes from a strip of out-of-the-money options across all strikes, the same replication that underlies the VIX. Because the payoff is in variance, it is convex in volatility: the long side gains more on a high realised outcome than it loses on an equally low one.
Example
Hypothetical: a trader buys a one-year variance swap at a strike of 20 with a vega notional of 100,000. The variance notional is 100,000 / (2 × 20) = 2,500. If realised volatility comes out at 25, the payoff is 2,500 × (625 − 400) = 562,500. At 15, it is 2,500 × (225 − 400) = −437,500.
On the desk
The short side carries the tail risk, which is why single-stock variance swaps usually include a cap, commonly 2.5 times the strike in volatility terms. Traders also check how market disruption days and missing closes are handled in the confirmation.
Educational definition. Worked examples are hypothetical. Not an offer or a recommendation.