Variance Swap is a bet on variance of some base asset. This is a swap contract, meaning that two sides agree on exchanging certain cash flows, one side pays a fixed amount in exchange of some uncertain amount based on the realized variance of some base asset.
A variance swap is a convenient way of hedging your vega risk or making profit if your estimation of future realized volatility is better than the market consensus.
The payoff of a variance swap can be roughly replicated with a portfolio of call or put options with weights proportional to inverse square of the strike price. As an example in this study the portfolio consists of long positions in one month puts with strikes of 7, 8, 9 and one month calls with strike prices of 10, 11, 12, 13 and the volume of each position is exactly 100 / strike² (e.g., for 9 put the amount is 100 / (9²) = 100 / 81 = 1.2345). As you can see, the vega graph is flat above 8 and below 11, meaning the price of the portfolio will respond linearly to changes in the volatility.
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The screenshot shows the following portfolio:
European call struck at 10.000 with expiry in 30 days
European call struck at 11.000 with expiry in 30 days
European call struck at 12.000 with expiry in 30 days
European call struck at 13.000 with expiry in 30 days
European put struck at 7.000 with expiry in 30 days
European put struck at 8.000 with expiry in 30 days
European put struck at 9.000 with expiry in 30 days
This is an excerpt from iOptioneer option trading reference application. In order to build the real-time dynamic strategy graph and run simulations you will need to download the application from App Store.