The purpose of this paper is to give an understanding of dispersion trading. This will be a multi-part paper starting with the most basic abstraction and then adding more detail. The math will add detail but is not necessary to understand the content.
Part 1 of a series
Any successful options trading captures the difference between what is expected (price today) and what actually happens (future price). Dispersion trading is the same: it tries to profit from the difference between stock and index correlation that is priced in the market today and what it will eventually end up being. This type of trade is typically done by being short index options (like the S&P 500) and simultaneously being long options on the individual stocks/components that make up the index. Dispersion trading is non-directional, meaning the trade does not inherently care if the market goes up or down, rather than what happens between implied and realized correlations.
Consider a basic example: we live in a world where there are three tradable assets.
Stock A
Stock B
Index AB, an equal-weighted index of A and B (i.e. 50% weight for each stock)
In this basic example, the Index AB will move as a function of its two stock components A and B. If A goes up 10%, and B goes up 10%, then index AB will go up 10%. Alternatively, if A goes up 10% and B goes down 8%, the index AB will have a net change of 1%.
The way this trade is commonly constructed is to buy options in stock A and stock B (profit from an increase in volatility - large moves are good) and to simultaneously sell options in Index AB (large moves are bad at the index level).
There are three trades being done at the same time:
Buy volatility (options) in stock A
Buy volatility (options) in stock B
Sell volatility (options) in Index AB
The perfect outcome of this trade is for volatility to go up (move around a lot in either direction) in what you are long volatility, and for volatility to go down (or don’t move at all) in what you are short.
A desirable outcome looks like this:
Stock A goes +10% (long volatility)
Stock B goes -8% (long volatility)
Index AB goes +1% (short volatility)
Here we can make money thrice, being long volatility in A and B, and short volatility in AB. We make money from our single stocks being more volatile than what was priced at trade inception (x2 stocks) and because we are short volatility in the Index AB those options would expire worthless and we keep all of the options’ premium.
Importantly, this trade is directionless and usually profits from unexpected news about individual stocks such as large earnings beats, large earnings misses, take-overs, scandals. Conversely, this trade can lose money from unexpected macroeconomic events that tend to push all stocks in the same direction at the same time.