Volatility Swap

A typical option pays off based on the difference between the actual price of an underlying asset (like a stock) and a particular strike price. Buy a call option with a strike price of $20 a share, and you're hoping that the actual price of the stock rises above $20. If it hits $25 on the expiration date, you make a profit of $5 a share.

A volatility swap works based on volatility rather than price. It's a forward contract that pays off based on the difference between the actual volatility an asset showed compared to the projected volatility as laid out in the derivative contract. This projected volatility works like a volatility strike. The swap acts as a bet that the realized volatility will be more than the volatility strike.

To give a little background, volatility measures the amount an asset's price moves around. A stock that stays in a range between $9.00 and $9.25 over a long period of time has very low volatility. Meanwhile, a stock that bounces around between $10 and $50 would have very high volatility.

Volatility doesn't care about direction. A big move up or a big move down...both represent a stock with high volatility. A volatility swap is just a bet on a certain amount of movement, without taking a guess as to...which way. It allows an investor to bet just on the size of the move, rather than predicting whether it will be up or down.

It's like asking someone to marry you on the third date. You're likely to get a big reaction one way or another...but it's tough to predict which way it will go.