The Most Profitable Strategy You’ve Never Heard Of
Before understanding how this strategy works, you must first understand the concept of implied correlation.
Implied correlation is a measure of the expected correlation between individual stocks in a basket, as priced by the options market. It reflects how closely the market expects the price movements of these stocks to be connected or related in the future. The higher the implied correlation, the more the market expects these stocks to move together.
For example, let’s consider two stocks: Stock A and Stock B. If the options market prices their options in a way that suggests that the prices of Stock A and Stock B are likely to move together in the future, then the implied correlation between these two stocks would be high. Conversely, if the options market prices suggest that the prices of Stock A and Stock B are likely to move independently or even in opposite directions, then the implied correlation would be low.
Dispersion Trading Theory
Dispersion trading aims to profit from the difference between the implied correlation and the realized correlation (the actual correlation) of a basket of underlying assets.
In a dispersion trade, an investor will sell options on an index and simultaneously buy options on some of the individual stocks that make up that index. By doing this, they are essentially betting that the implied correlation of the index is overpriced compared to the future realized correlation. If the realized correlation is lower than the implied correlation, the trader will profit from the difference. This trade relies on the principle that the diversification effect is usually overestimated by the market.
Here’s a step-by-step breakdown of how it works:
- Identify the index and its constituents: Choose an index and its component stocks to build the dispersion trade. For this example, let’s consider the S&P 500 index (SPX) and a subset of its constituents: Apple Inc. (AAPL), Microsoft Corporation (MSFT), Amazon.com Inc. (AMZN), and Alphabet Inc. (GOOGL).