Quant Lab
Equity Dispersion
Tages Capital
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Authors
Berouz Fatemi
Head of Quantitative Strategies
Tages Capital
Sébastien Krol
Portfolio Strategist
Tages Capital
Overview
The persistent low rate environment has once again increased the popularity of
structured products amongst retail investors. This has resulted in an improvement
in the volume of single stock options transactions, especially in the US. Relatively
cheap single stock options in comparison to stock index options has, in turn,
generated more interest in dispersion trading amongst banks, hedge funds and
other derivatives traders.
For many years, investors have viewed dispersion trading as an effective strategy
to take advantage of a structural imbalance in the equity options market. A
dispersion trade entails selling volatility (i.e. selling options) on an index against
buying volatility on the index’s constituents. Because dealers are generally short
volatility on indices (due to investors buying options for portfolio protection) and
long volatility on individual stocks (due to investors’ covered call-writing strategies
and structured product purchases), index options have historically had a higher
implied volatility premium than their single-stock counterparts.
Dispersion can be implemented through options, variance or volatility swaps. It
can also be executed in many forms such as vega- or theta- neutral, using different
maturity options and in various types of bespoke baskets of single stocks. Different
implementations offer a wide range of exposures and outcomes that investors can
design according to their portfolio requirements.
2
Basic Concepts
Going short index implied volatility and going long benefit of diversification is the reduction in the
single-stock implied volatility is known as a volatility of a portfolio. The volatility of an index is
dispersion trade. Correlation exposure which is capped at the weighted average volatility of its
historically achieved through such dispersion trades constituents. Due to diversification (or less than
is a measure of the tendency of share prices to 100% correlation), the volatility of indices tends to
move together; its most common incarnation is trade significantly lower than its constituents. The
seen in the “diversification effect” in portfolio VCA (Volatility Correlation Analysis) function on
theory. From basic portfolio theory, in a portfolio of Bloomberg provides investors with high level
stocks, the return of the portfolio is additive, analysis of this on major stock indices.
although the risk (or volatility) is not; an observed
Fig 1. Impact of Single Stock Correlation on Index Volatility
2 stocks, correlation +100% Index
21.00 105.00
20.50 104.00
20.00 103.00
102.00
19.50
101.00
19.00
100.00
18.50
99.00
18.00 98.00
17.50 97.00
17.00 Volatility = 30% 96.00 Volatility = 30%
16.50 95.00
1 2 3 4 5 1 2 3 4 5
Stock1 Stock2
2 stocks, correlation -100% Index
21.00 105.00
104.00
20.00 103.00
102.00
19.00
101.00
18.00 100.00
99.00
17.00 98.00
97.00
16.00
Volatility = 30% 96.00 Volatility = 0%
15.00 95.00
1 2 3 4 5 1 2 3 4 5
Stock1 Stock2
Source: Bloomberg
Flows from retail structured products as well as call- market behaviour of index volatility trading rich
overwriting funds provide a structural supply of relative to constituent stock volatility; this strategy
single stock volatility in the market resulting in a aims to capture the sale of this “rich” volatility,
relative cheapness of single stock volatility whilst eliminating the significant risk of a short
compared to the index implied volatility. The exposure to volatility.
strategy looks to capture the historically observed
3
Basic Concepts
Generally, a noticeable trend has been for implied trade on the index volatility against a long position
correlation to trade rich relative to realised on the single stocks; as the correlation is less than
correlation, as a consequence of index implied one, a given increase in single-stock volatilities will
volatility trading rich relative to the constituent lead to a smaller increase in index volatility levels.
single-stock volatility. This thesis supports a short
Fig 2. SPX Implied & Realised Correlation (6 months) 1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Implied Realised
Source: Tages Capital
An investor can gain exposure to the implied vs. position creates a short correlation exposure for the
realised correlation spread by trading index investor. A short correlation trade is typically
volatility vs. single stock volatility. A short index termed a long dispersion trade.
vega (volatility) position vs. a long single stock vega
Fig 3. Dispersion Trading
Dispersion Correlation Index Leg Stock Leg
Short index Long stock
Long dispersion Short correlation
Short dispersion
= Long correlation
volatility
Long index
volatility
Short stock
volatility volatility
Source: Tages Capital
1 Index correlation (square root) can be approximated by the ratio between the index volatility and the average of
single stock volatilities: 𝑝 = 𝜎σ𝐼𝑛𝑑𝑒𝑥
𝑤 𝜎
𝑖 𝑖
4
Dispersion Schemes
There are two main types of dispersion trades: ▪ Theta or correlation-weighted dispersion: the
vega-weighted and theta-weighted dispersion total vega notional of the single stocks is scaled
trades. Each of these trades is driven by the by the square root of the index correlation. This
apparent difference in their weighting schemes. means there is a smaller single-stock vega leg
compared to the vega weighted approach
▪ Vega-weighted dispersion: the vega notional of (single-stock volatility is larger than index
the index is equal to the total vega notional of volatility, so it must have a smaller vega for vega
the single stocks. This dispersion strategy has × volatility to be equal).
both correlation and volatility exposure (i.e. a
long vanilla dispersion is short correlation, but is
also long stock volatility).
Fig 4. Historical Performance: Vega Neutral vs. Theta Neutral
220
200
180
160
140
120
100
80
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19
Vega Neutral Theta Neutral
Source: Citigroup
There is usually a preference for a vega neutral preferred in a high correlation / high volatility
implementation in a low correlation / low volatility environment. This can be explained by the fact that
environment. The largest driver of performance for the largest driver of performance for a theta neutral
this strategy is changes in implied vs. realised dispersion trade is the implied-realised correlation
volatility in the market, where the correlation spread, where such correlation premium (implied-
premium (implied-realised correlation) acts as a realised correlation) gets effectively multiplied by
financing leg for the maintenance of the long the average realised single stock’s volatility.
volatility position. A theta neutral implementation is
Fig 5. Implementation: Vega Neutral vs. Theta Neutral
Vega Neutral Theta Neutral
Long/short Index Vega notional: 𝑁 𝑣𝑒𝑔𝑎 𝑁 𝑣𝑒𝑔𝑎
relative weighting
(Vega notionals) Single stocks notional: 𝑁𝑖 𝑣𝑒𝑔𝑎 = 𝑤𝑖 × 𝑁 𝑣𝑒𝑔𝑎 𝑁𝑖 𝑣𝑒𝑔𝑎 = 𝑤𝑖 × 𝑁 𝑣𝑒𝑔𝑎 × 𝑝
with 𝑝 = σ 𝑤𝑘1×𝑘
𝑖 𝑖 𝑖
𝑘1 the index strike
𝑘𝑖 the single stocks strikes
Source: Tages Capital
5
Implementation: Instruments
The development of pure volatility instruments such exposure on both legs of the trade, variance swap
as volatility and variance swaps in the 1990s, dispersion can help investors better isolate
allowed investors to take more stable exposure to exposure to correlation and avoid potentially large
the correlation premium by eliminating the path- net volatility positions. Examples of commonly
dependency issue which exists in volatility trading utilised instruments are listed below.
with listed options. By ensuring consistent volatility
Options Variance swaps
✓ Implementation through puts / calls / straddles / ✓ Variance swap (or var swap) is a contract that
strangles. Either listed or OTC enables investors to trade future realised
✓ Can be traded in a systematic strategy variance against current implied variance
✓ Can be executed on major markets × Less liquid and only available in the US
Volatility swaps Exotic options
✓ Volatility swap (or vol swap) is a contract that ✓ Exotic options enable investors to engage in
enables investors to trade future realised dispersion trades involving options on single
volatility against current implied volatility stocks against options on a basket of stocks
✓ Can be executed on major markets (instead of an index)
× Much less liquid and can usually only be
unwound with the initial counterparty
Dispersion has been traded in the past using times the strike price. This caused some large losses
variance swaps; however since the decline in the in 2008 which resulted in diminishing interest in
liquidity of single stocks variance swaps, dispersion variance and volatility swaps.
using equity options has become the standard
correlation vehicle in the equity derivative world. For investors looking to trade dispersion via listed
options, path-dependency dynamics are a major
Trading dispersion through options might sound issue. Depending on the evolution of underlying
somewhat simplistic, but it is a cheaper solution security prices, a dispersion investor could end up
than trading swaps or OTC products and is often with a significant net volatility position between the
more liquid. The other downside to variance and legs. This is the reason why trading dispersion with
volatility swaps is that market makers tend to listed options has a “noisier” P&L than doing so with
impose a capped pay-out for swaps of about 2.5 pure volatility instruments.
6
Path Dependency of Options
Path dependency of options refers to the fact that option varies with strike. In this case, we see a 3m
an option’s Greeks (vega, gamma, etc.), change as ATM option, showing how the volatility exposure
market moves away from the initial strike. The chart rapidly changes as the share price moves away from
below illustrates how the vega exposure of a vanilla strike.
Fig 6. Volatility Exposure (3m option)
0.25
0.20
0.15 Option strike price = 90%
Vega
0.10 Option strike price = 100% (ATM)
0.05 Option strike price = 110%
0.00
-0.05
50 70 90 110 130 150
Strike Price
Source: Tages Capital
Trading dispersion through options, often executed by investors. In such market conditions, the index
through listed straddles, has an interesting path could move far away from the average strike in the
dependency dynamic which could be an issue at portfolio and thus lose most of its volatility features
times when individual stocks trend in the opposite (gamma and vega). Individual stocks are expected
direction to the index. This could result in mostly to follow the index away from their strike,
unchanged index performance whilst the stocks but some might be more resistant and still trade
have deviated significantly from their original strike close to their strike, exposing the strategy to long
level, meaning we would no longer capture gamma as in the chart below. Also as individual
“correlation”. This could be remedied by executing stocks usually have higher implied volatilities than
a new set of at-the-money options at regular indices, they generally maintain their realised
intervals (monthly, for example). During sharp sell- volatility exposure over a wider range of prices.
offs, this path dependency feature can be exploited
Fig 7. Volatility Exposure: Index vs. Individual Stocks
Lower Vega Lower Vega Lower Vega Lower Vega Lower Vega Same Vega Same Vega Lower Vega Lower Vega Lower Vega Lower Vega
0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20 0.20
Vega 0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.15
0.10
0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150 50 70 90 110 130 150
-0.05 -0.05 -0.05 -0.05 -0.05 -0.05 -0.05 -0.05 -0.05 -0.05 -0.05
Spot Spot Spot Spot Spot Spot Spot Spot Spot Spot Spot
2.0%
1.0%
0.0%
Underlying Returns
-1.0%
-2.0%
-3.0%
-4.0%
-5.0%
-6.0%
Index stock 1 stock 2 stock 3 stock 4 stock 5 stock 6 stock 7 stock 8 stock 9 stock 10
Source: Tages Capital
7
Dispersion Styles
There are various ways to trade dispersion. ▪ Bespoke dispersion: investors might want to
Investors can trade via a process driven choose the basket of single stocks on which they
implementation, or may want to express their own place their dispersion trade. In this case, not all
view on the behaviour of the index correlation and the names may be in the related index, which
its components. makes it difficult to weight the stock options as
in the index. However, this type of trade allows
▪ Full dispersion: Options on all single stocks in an the investors to tailor their exposure along with
index are purchased against an option on the their view on future correlation behaviour and
index respecting individual stocks weights. In the relative cheapness of individual stock
practise, this type of trade is focused primarily volatilities. Bespoke implementations allow
on indices with smaller number of constituents investors to express investment themes by
such as EuroStoxx 50. selectively exposing their strategy to a specific
sector in order to benefit from intra-sector
▪ Quasi-full dispersion: For some indices, not all volatility or sector rotation. Or, for example,
the constituents are tradable (or the index interest rate sensitive strategies can be
contains too many stocks). It is common practice positioned for moves in interest rates, regardless
for these indices to take into consideration only of the direction.
a percentage of the market cap, looking at the
vega notional of each stock scaled by the ▪ Geometric dispersion: This style involves selling
adjusted weight in the index (e.g. SPX top 50 volatility (often in exotic shape) on a bespoke
dispersion) to ‘approximate’ the index. geometric basket of stocks and buying back
Consequently, the dispersion effect is quasi- volatility on the individual components. This
replicated since the majority, but not all, of the relative value strategy plays the mean reversion
capitalisation is traded. between the realised volatility of both single
stocks and their geometric average compared to
implied volatility levels. Geometric dispersion
can be traded via variance swaps, volatility
swaps or options.
8
Conclusion
Dispersion trades can be implemented in very simple or complex ways with a
diverse range of outcomes. The most efficient implementation uses listed options,
executed at different intervals such as weekly or monthly, minimising the path
dependency issue. As noted previously, the vega neutral weighting methodology
provides the investor with a residual long vega exposure. This is the
implementation that we are most interested in for the Paladin UCITS Fund as it
provides the portfolio with inexpensive downside protection.
Most investors engage in dispersion strategies as an arbitrage between cheap
single stock volatility and rich index volatility, aiming to benefit from the risk
premia carry offered by a theta neutral strategy. Most bespoke implementations
have been also designed to pick the cheapest single stock volatilities against a
basket or index, maximising the embedded carry.
Bespoke structures need to be executed on both sides of the trade (opening and
closing a position) with a single bank counterparty. These may seem very simple
and intuitive, but equity market and dispersion trading experience is needed to
distinguish the intricacies of sector rotation and other nuances.
We hope this note can help you better understand the various forms and shapes
of this interesting strategy and its often needlessly complicated terminology.
9
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