Options and volatility · O9 · 9 min
Volatility products and flows
Explain how traders bet on volatility directly, and who wins or loses when it jumps.
In the news: “Volatility sellers were caught out”: how betting on calm markets can lose years of gains in a day.
The essentials
- VIX futures and the roll
- The can’t be bought, only futures on it. In calm markets they sit above it, in , and drift down as expiry nears, so funds that keep rolling them lose value; in a sell-off the curve flips to .
- Variance swaps
- A pays on squared against a strike, so a spike gains more than a lull loses: on £100,000 vega notional struck at 20, realised 25 pays £562,500 and 15 costs £437,500.
- Short volatility
- positions, such as sold options or short VIX futures, make small gains most days and large losses rarely. On 5 February 2018 a spike cut XIV, a short-VIX product, by 80% or more in a day.
- 0DTE options
- expire on the day they trade; S&P 500 index options have had an expiry every trading day since 2022. With hours left, at-the-money options swing hard on small moves and lose value fast.
- Dispersion
- A sells volatility on an index and buys volatility on the index’s shares. It wins when the shares move a lot but separately, and loses when they fall together and correlation jumps.
Variance swap P&L
P&L ≈ N_vega × (σ² − K²) ÷ (2K)
- N_vega
- vega notional: roughly the P&L per volatility point near the strike
- σ
- realised volatility over the swap’s life, in points
- K
- the strike, in volatility points
How it works
1. Trading the VIX
You can’t buy the itself, only futures on where it will be on set dates. A VIX future for next month might trade at 18 while the VIX is at 15, because the VIX tends to rise from calm levels over time.
2. Contango and the roll
When each later future is priced higher than the one before, the curve is in . A future at 18 slides towards a VIX of 15 as its date nears, if nothing changes. Funds that hold VIX futures keep selling the expiring one and buying the next, dearer one, so they lose value steadily in calm markets.
3. When fear spikes
In a sell-off the VIX can jump above the futures, so each later future is lower than the one before: . Then VIX futures gain as they rise towards the higher VIX. That is the moment these products are built for.
4. Variance swaps
A pays on how much a price actually moves over its life, with no options or hedging needed. You agree a strike, say 20. If realised volatility comes in above 20, the buyer gains; below it, the seller gains.
5. Variance swap P&L
Its size is set in vega notional, roughly the P&L per volatility point near the strike. P&L ≈ vega notional × (realised² − strike²) ÷ (2 × strike). With £100,000 and a strike of 20, realised 25 pays £100,000 × (625 − 400) ÷ 40 = £562,500.
6. Why the squares matter
Because it pays on volatility squared, a variance swap is lopsided: realised 25 gains £562,500, but realised 15 loses only £437,500. So a buyer gains more from a spike than they lose from a calm patch of the same size.
7. Selling volatility
positions, such as sold options or funds that are short VIX futures, make small gains most days and large losses rarely. On 5 February 2018 a volatility spike cut the value of XIV, a Credit Suisse product that was short VIX futures, by 80% or more in a day, and Credit Suisse closed it.
8. Same-day options
expire on the day they trade. With hours left, an at-the-money option swings hard on small moves and loses its remaining value fast; options out of the money fade to nothing. S&P 500 index options have had an expiry every trading day since 2022. The worry is that dealers hedging big same-day positions could make late-day moves bigger.
9. Dispersion
A sells volatility on an index and buys volatility on the index’s shares. It wins when the shares move a lot but separately, and loses when they all fall together and correlation jumps.
Worked example
You buy a one-year variance swap on a share index with a vega notional of £100,000 and a strike of 18. The year is turbulent: realised volatility comes in at 26.
- Variance notional = £100,000 ÷ (2 × 18) = £2,777.78 per variance point.
- Realised² − strike² = 26² − 18² = 676 − 324 = 352.
- P&L = £2,777.78 × 352 ≈ +£977,800.
- A straight vega estimate says 8 × £100,000 = £800,000; the squares add about £177,800.
- Had realised been 10: £2,777.78 × (100 − 324) ≈ −£622,200, a smaller loss than the straight −£800,000.
About +£977,800: a variance swap gains more from a spike than it loses from a calm year of the same size.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Why do long-VIX ETFs lose money over time?
What’s a variance swap?
What are 0DTE options, and why do people worry about them?
Remember
Var swap P&L ≈ N_vega × (σ² − K²) ÷ 2K
Short volatility earns small and often and loses large and rarely; contango makes long-VIX products pay to wait.
Sources
- Credit Suisse — Credit Suisse media release on the XIV event acceleration, February 2018
- Cboe Global Markets — Cboe to Add Tuesday and Thursday Expirations for SPX Weeklys Options
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.