Trying to wrap my mind around a simple concept. Dispo trading is a strategy that profits in low / zero corr environments, obv. Short index vol, long component vol. Eg short SPX vols, long some single name vols. During crisis, index vol skyrockets, which is all the more devastating given the severe vol smile inherent in index vol. But wouldnt your index short vol loss be somewhat mitigated by your long vol position in single name? I know the smile isnt as pronounced in single names as it is in indices, but it still exists. So wouldnt a dispo trade always beat a naked short vol position? Unless, of course, youre holding the SN into some *even lower* single name vol event like earnings crush
A number of ways to do it, but the two biggest challenges are it takes a ton of capital and it gets very crowded very fast. There's also the issue of being wrong. Trade is dominated by the banks that already have index or vol. desks Does it beat naked short vol. Is somewhat of an unfair question. The risk profiles aren't a fair comparison. Trading an event would more likely be two verticals with different expirations. Again, you need to go big.
Can you elaborate? I know it can get pretty up there in complexity esp since banks are typically holding baskets of single names, but for my purposes I'm just looking to incorporate maybe a few as a way to offset risk and improve returns of a naked short index vol strategy I've been work on
no. Because to be vol beta flat you often trade 1.3x index vol to single stock vol. so you are naked short. If you traded 1x then you are right but then you are vol bets long in the quiet times and will bleed.
What is their to wrap your mind around? Sell Straddles and buy /VX contracts when things get dicey. Easy Peezy.
Main problem with dispersion strategies is the fact that unknown events make correlation go up a lot, making the strategy always be short the black swan.
The correlation isn't typically the problem if you are diversified enough. It can only cap at 1. The issue is the vol explodes too. The art of dispersion is 1. the basket (stock selection) 2. the ratio of index hedge to single stock. The latter is what really fucks you when correlation goes up a lot.