dispersion strategy

Discussion in 'Options' started by Andrico, Dec 10, 2008.

  1. Andrico


    Good day traders.

    I'm curious whether anybody can share his knowledge/experience on the topic of dispersion strategies. I just recently read an article about it, but it left me with more questions than answers.

    The basic idea is to find two securities, typically a stock (stocks) and the corresponding index and bet on the dispersion between the two. For instance one can long the stock and short the index. In case one uses options, he can create "approximately" vega-theta-gamma neutral strategy, while the deltas will be different in his adventage.
    They say the advantage of this strategy can be the hypothesis that prediction of the relative movement between two busket of securities can be somewhat easier than the prediction of the absolute direction of one security.

    Has anybody successfully done this?

    I created a few graphs of the relative movement between say, AAPL and SPY or DIA, but I wouldn't say that those graphs looked much more "predictable" than the graphs of the underlying.

    Best regards,
  2. MTE


    As far as I know, dispersion is not about directional movement, but about volatility of the basket of securities (individual index components) vs. volatility of the index, as well as correlation.
  3. MTE is correct.

    The basic idea is to exploit a discrepancy between the implied volatility of an index option and the implied volatility of that index's constituent stock options.

    For any given stock option IV and it's weighting within the index you can derive an implied correlation of the component stocks. When the implied correlation is high (>0.75) you'd want to be long the component stock options and short the index options (long dispersion / short correlation). Whenever it's low (<0.25) you might think about going short the component stock options and long the index options (short dispersion / long correlation), but this way around carries significant risk.

    It's complicated, suggest some serious study before attempting anything that resembles a dispersion trade.