Dispersion Trading

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21 Aug, 2024

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Dispersion trading refers to leveraging the difference between the volatility implied by index options and implied individual constituent stock options volatility within the same index. It aims to profit by exploiting discrepancies between the implied volatility of individual stock options and the underlying index compared to overall market movement.

Traders use it to generate profits when the implied volatility of the index price exceeds that of individual stock options. It can be Vega-weighted as it involves buying At-The-Money (ATM) straddles on the components and selling ATM straddles on the index. This trading option is generally complex for investors.

What is Dispersion Trading?

Dispersion trading is a tool for leveraging the discrepancy between the implied volatility of index options and the implied volatility of individual participating stock options within the same index.
Investors or traders make profits by benefitting from the difference in implied volatility between the movement of the underlying index and the individual stock options as against the overall market trends.
It focuses more on the risk of mispricing index options in contrast to individual stock options, while correlation trading centers on the risk of return between various assets moving about each other.

Dispersion Trading Explained

The dispersion trading strategy aims to capitalize on discrepancies between realized and implied volatility or the association between the index and its constituent stocks. Based on volatility variations, it involves selling options on an index and purchasing options on its constituent stocks or vice versa. As a result, it aims to achieve a market-neutral position to benefit from such disparities.

It mainly focuses on a volatility arbitrage strategy that exploits volatility discrepancies. It allows investors to benefit from the low association between constituents and the index for greater profits. However, the strategy involves intricately selecting options and stocks through deep research and analysis. It is considered a complex technique that adds to the sophistication of options trading. Furthermore, volatility dispersion trading, geometric dispersion trading, and dispersion trading options are essential elements of a complex trading strategy.

It also impacts investment risk as higher dispersion means higher market risk and vice versa. Portfolio diversification plays an important role in offsetting the negatives of assets contained with low correlation. Market efficiency is inversely related to dispersion.

Moreover, it provides a method to leverage financial market volatility mismatch and association variations. Advanced traders primarily use it to profit from it because they can deal with its complexity and have a deeper understanding of market dynamics and options. In the financial world, traders use it to generate alpha using precision hedging and leveraging market inefficiencies. It affects liquidity providers by hedging risks through option-based strategies. Moreover, the NASDAQ 100 is well-suited for trading based on dispersion.

Examples

Let us take a look at a few examples to understand the topic.

Example #1

Let us assume an index named Growth Index comprising 100 stocks. The gap between the implied volatility of the growth index and the realized volatility of individual stocks is quite large. Hence, a dispersion trader, Alex, implements a trading strategy based on dispersion where he buys cheaper options and selects a few individual stocks from the index simultaneously.

Such a careful individual stock purchase and adjusting the option position mitigate the directional risk. The trader derives good profit from mispricing the realized and implied volatility by selling high-priced index options and buying cheaper options on individual stocks.

Example #2

In the middle of 2023, it was observed that U.S. stocks were moving less in sync, with the S&P 500 correlation nearing a record low in June. Various individual stocks are moving in different directions, portraying opportunities for stock pickers. Hence, traders could engage in long dispersion trades, betting on individual stocks' low correlation. Additionally, low correlation has made index options cheaper, making them more attractive for investors seeking volatility protection.

It is possible to understand the concept with the help of a suitable example in the form of a chart from TradingView. The chart below relates to Euro FX Futures; in the chart, there are five pairs of Foreign Exchange within the basket, out of which the Z Score is calculated. In this context, the Z Score is used to describe the relationship between a value and the means of a certain group of values. Then, a composite is calculated using the 30 and the 60 Exponential Moving Average (EMA) of the z-score so that the fluctuations are smoothened out.

In the chart below, the Z Score has been used in one such FX pair out of the basket, and the chart is on a one-minute timeframe. Thus, dispersion calculates the fluctuations. In the chart, the dispersion is more above the 0.5 line and is less below the 0.5 line.

Source

Dispersion Trading vs Correlation Trading

The main differences between the two are as follows:

Dispersion Trading	Correlation Trading
Profits from price differences between index and stock options	Profits from how asset returns move together
Works best when differences are high or correlations are low	Works best when correlations decrease
Low differences reduce potential profits	Low correlations create profit opportunities
Active and passive investors use it to identify trading opportunities	Contribute to understanding portfolio diversification and asset relationships

Frequently Asked Questions (FAQs)

What is the importance of dispersion trading?

Dispersion trading is important for experienced investors. It allows for capitalizing on variations in implied volatility, enhancing portfolio returns, and hedging against market risk. By understanding and identifying these disparities, traders can potentially generate profitable returns and diversify their investment strategies.

When to use dispersion trading?

It is applicable when the discrepancies between the implied volatility of index options and individual stock options within the same index occur. This strategy is suitable during periods of heightened market uncertainty or when there are significant deviations in implied correlation levels between the index and its constituent stocks.

What is a long dispersion trade?

A long dispersion trade involves taking a buy position on the dispersion between the implied volatility of index options and individual stock options within the same index. Traders expect that the implied volatility of individual stock options will increase relative to the index options, resulting in profit from the pricing discrepancy.