The Most Profitable Strategy You’ve Never Heard Of
Step into the high flying world of dispersion trading.
Before understanding how this strategy works, you must first understand the concept of implied correlation.
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.
Trading Use-Case
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).
- Sell options on the index: Sell an at-the-money (ATM) straddle on the S&P 500 index. For example, if the S&P 500 is currently trading at 4,000, you would sell a call and put option with a strike price of 4,000.
- Buy options on the individual stocks: Simultaneously, buy ATM call and put options on the individual stocks (AAPL, MSFT, AMZN, and GOOGL) with the same expiration date as the index options.
- Calculate position sizes: Determine the weights of the individual stock options based on their relative importance in the index. This can be done using the market capitalization or the beta-adjusted weight. Make sure to adjust the notional value of the options on the individual stocks to match the notional value of the index options.
- Monitor the trade: Monitor the price movements of the index and the individual stocks over time. If the realized correlation is lower than the implied correlation, the value of the options on the index will decrease, and the value of the options on the individual stocks will increase, leading to a net profit.
- Close the trade: Close the trade by buying back the options on the index and selling the options on the individual stocks. The profit or loss will be the difference between the premium received from selling the index options and the premium paid for buying the individual stock options, adjusted for transaction costs.
This is definitely a very complex strategy (which is why it isn’t popular), but it is clearly quite useful and provides extra uncorrelated returns. Can’t thumb your nose up at that, right? :)
If this article piqued your interest, you’d likely enjoy some of my other posts just like this one:
- Arbitraging The Implied Correlation Index
- I Found A Way to Arbitrage Your 401(k)
- It’s Showtime: Our Sports Betting Algorithm is Live and Profitable! [Code + Data Included]
Happy trading! :)
