Exploiting a volatility view

The most obvious use for variance swaps is to express a direct view on the volatility of the underlying.

Delta-hedged options can be used for this purpose but have two principal drawbacks:

Variance swaps have none of these issues and provide a pure exposure to volatility.

At the index level, investors may use variance swaps to express a macro view.
On single-name underlyings, variance swaps could be used to take a view on the uncertainty of a company.
Another use of variance swaps is to take advantage of an expected structural change in a company.
Variance swaps can also be used by investors to express their view on the likelihood of an M&A event.

Example 1:

Bull market, an investor expects a sharp downwards correction at some stage in the future, say within a year.

- he does not want to sell his position as market may rally further.

- put options are possibility for hedging but will need to be re-restruck to roll up protection as market rallies.

- long VS can prove profitable if correction relatively sudden and occurs within maturity of the VS.

However, the investor:

- must be careful to maintain the required volatility exposure

- must consider whether an exposure to RV is desirable

- must compare the negative carry from holding long VS position to the put premium

Example 2:

An investor expects a quiet market, which may gradually trend up. He wants to boost his alpha based on this view.

- Straddles are not perfect:

low vol market often displays trending behaviour --> delta-hedging
even delta-heding will prove sub-optimal --> away from strikes --> decreased exposure to volatility through decreased gamma.

- Selling VS is efficient and non-path-dependent way of capitalising on this low volatility view.

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