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Trading realized variance using listed vanillas

Published in Automated Trader Magazine Issue 40 Q3 2016

Listed futures on VIX and its cousins give exposure to implied variance. But getting exposure to realised variance is very different and usually has been the realm of OTC variance swaps. Here we examine strategies to trade the realised variance using only listed instruments, with simple time-independent formulas not requiring models such as Black-Scholes.

Buy-side agents have been trading realised variance with banks since at least 1996, typically selling it to them using OTC variance swaps. In recent years variations such as OTC variance options have also been very popular. It seems that many participants find it easier to take a trading view on realised variance rather than implied variance, especially over fairly long time scales and slower frequencies.

Several exchanges have tried to jump on this bandwagon, creating listed contracts replicating OTC realised variance swaps, but all of these have failed to gain traction. This might be because although OTC contracts are highly standardized, the operational details, surprisingly, turn out to be too complex. As an example, Eurex tried to list variance futures several years ago with a very complex system on the back-end for mirroring the OTC flow of payments, but these never took off.


Alberto Cherubini and Trevor Samols started EQ Finance ( in 2009, having spent many years in various trading and quant roles in the equity derivatives front-office of major banks. Prior to this, they pursued doctorates and research work in physics and applied mathematics, respectively.

While OTC contracts provide exposure in a simple, trouble-free way, they also suffer from various limitations: Some agents cannot use them at all, exact tailoring to a particular exposure may not be available, and their liquidity has reduced in recent years (i.e. wider bid/ask spreads and lower volumes). Here we shall discuss how to avoid these issues and trade various realised variance strategies directly in the listed vanilla option markets.

In this treatment, the level of implied volatility in the market is only involved at the inception of the trade: we implicitly assume that Mark-to-Market (MtM) considerations are not relevant, so that the agent does not care about daily fluctuations in the MtM P/L caused by changes in the market implied volatility, and that the only relevant P/L is the one at maturity.

The way banks typically model and hedge OTC variance contracts is somewhat different: In addition to attempting to match the precise contract specifications, they must also continue to MtM the contract after inception and, consequently, must take into account market option prices for the lifetime of the trade.

In practice of course, every agent has stop-loss limits or margin calls, so the relevant criterion is whether these limits (or equivalently, the pain threshold for margin calls) are wide enough that the probability they are triggered by a worst-case move in implied volatility is acceptably low. In particular, the possible worst-case scenario will increase with longer maturity, and hence restrict the maturity T tradable for a given agent.

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