Dispersion trading arbitrage strategy
The dispersion trading uses the fact that difference between implied and realized volatility is greater between index options than between individual stock options. A trader could therefore sell options on index and buy individual stocks options or vice versa based on this volatility difference.
Dispersion trading is a sort of correlation trading as trades are usually profitable in a time when the individual stocks are not strongly correlated and loses money during stress periods when correlation rises.
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The correlation among the securities are used as a factor to determine the entry of a trade. Depending on the value of correlation between individual stocks, the dispersion can be traded by selling the index options and buying options on index components or by buying index options and selling options on index components. The most well-received theory for the profitability of this strategy is market inefficiency which states that supply and demand in the options market drive the premiums which deviate from their theoretical value.
To distinguish dispersion trading, it is simply a hedged strategy which takes advantage of relative value differences in implied volatilities between an index and index component stocks.
It involves a short options positions on securities of index and a long options positions on the components of the index or vice versa. We have to note that this trade would be successful only when the delta exposure is close to zero. Thus the dispersion strategy is hedged against large market movements. The profit from this strategy comes from the fact that correlation tends to mean revert.
Thus if one takes positions during the extremes of ratio, we can be assured that it would mean revert at a certain point.
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To implement the strategy, we would be needing to calculate the below: Calculating Implied volatility of nearest Strikes Since we would be having the Premiums, time to expiry, Interest Rate, Dividend and the nearest Strike, we can compute the Implied Volatility of the nearest strikes using the Black Scholes model. The weighted average Implied Volatility among the nearest strikes needs to be added for the individual securities and Index in order to calculate the Correlation Dirty Correlation: This is the square of ratio of the Implied Volatility of Index and Weighted average of Stocks.
Thus the formula would be. The nearest 3 OTM strikes are considered in this project. The investment amount needs to be equally split amongst the Index and Individual securities.
Stratégies de trading de volatilité
Answer: it ends up unchanged. Now let us consider the following sample trade. What happened? The fact that the stocks returns are correlated results in an equally important move in the index. The loss on the short straddle position in the index superseded the overall gains on long straddle positions on stocks. Since correlation has a major impact on profitability, our desks continually look at potential scenarios to decide potential returns from the strategy before entering a trade. The correlation among the securities are used as a factor to determine the entry of a trade.
Depending on the value of correlation between individual stocks, the dispersion can be traded by selling the index options and buying options on index components or by buying index options and selling options on index components. Dispersion trading is complex strategy however this is rewarded with the strategy being a profitable one which offers high rewards in response to a low risk.
Trading at times where volatility is high viz.
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PL Desk advises its clients on such strategies and initiates these around expiry time each month. The Bank Nifty is typically preferred due to its lower number of stocks as well as correlations inherent in the index and has proven to generate substantially attractive risk adjusted returns over the past 18 years and has proven to be extremely profitable performance can be shared in person.
The only limitation however is that the creation of a market neutral strategy for a client would require a margin of about Rs 1. The returns however are substantial and therefore such a commitment would be justifiable especially as the product also has fairly low number of trades and thus transaction costs. The ideal time horizon for a client is advised at between 12 to 18 months to let the laws of probability play out on the capital.
One also has the opportunity to talk to our desks to customise indices or straddles in line with personal views on expected correlation. So if you are interested in creating this strategy for your portfolio, email us at tea plindia. You must be logged in to post a comment. Investors can enter a trade when the two stocks get substantially out of sync with each other, such as in mid-February and in early May. However, there is no guarantee of when the two prices will re-converge; therefore, investors should always consider using stop-loss orders when employing this strategy.
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