Navigating the trading waters of recent option markets has proved a formidable challenge for portfolio managers, whose traditional volatility option strategies have often yielded underwhelming results. Against this backdrop, option dispersion trading has emerged as an outlier, delivering robust performance where other volatility methods have failed. This option strategy isn’t just a simple play on numbers; it’s a calculated bet on the volatility gap and correlation difference between index options and the options of individual stocks within that index
Introduction to Dispersion Trading (Implied Correlation Trading)
Dispersion trading exploits the variance in expected volatility between index options and options on the individual stocks of the index. Generally, the implied volatility in index options is not low enough compared to the implied volatility in stock options. This inconsistency leads to opportunities to benefit from the fluctuating spread.
A key element of dispersion trading is understanding the concept of Option-Implied Correlations. These correlations offer insights into how closely individual stocks are expected to follow the movements of their broader index. When these correlations are high, it indicates that stocks are likely to move in harmony with the index, presenting fewer opportunities for dispersion trading. On the other hand, when correlations are low, suggesting a greater likelihood of individual stock movements deviating from the index, the conditions become ripe for dispersion trading. This divergence is where the strategy truly shines, providing the openings traders seek to capitalize on.
In recent times, the strategy of dispersion trading has gained traction as traders seek effective ways to generate alpha. Often, the complexity of dispersion trading is overemphasized in literature. For this purpose, ThetaTitans comes to the rescue. They describe how it works in detail and even provide examples. You can find it on https://thetatitans.com/home/dispersion-trading/.