Variance is a measure of the spread of a set of data, while volatility is a measure of the deviation from the average value. Both are financial instruments used to speculate in future price movements of an asset, but as variance equals the square of volatility, the payoff of a variance swap rises more sharply with increased price movements. In practice, variance is always the square of volatility.
In both variance swaps and volatility swaps, one party to the deal agrees to the future payment of a fixed amount, called the strike, while the other agrees to pay relative to the price movements of an underlying asset, such as a stock index, a currency or a commodity index. It does not matter whether the price of the asset rises or falls during the time covered by the swap. Rather, the size of the of them movements is relevant. At the end of the term of the swap, the difference between the strike and the volatility- or variance-based position is calculated to determine which party owes the other.
Investors can use either instrument to speculate on volatility or to hedge against volatility exposure in other positions. Variance swaps are the more commonly used of the two.