Seeing this headline at MarketBeat, "Good News for Stock Pickers: Correlations Finally Dropping" combined with this morning's German High Court ruling on the constitutionality of German backing for the European Stability Mechanism reminded me that I had planned to post something on dispersion trades.
Digging into the link-vault, Condor Options had a couple posts last year, starting with "Trading the End of the Risk On / Risk Off Environment" that give a nice intro to the concepts:
What if the “risk on / risk off” market environment comes to an end, even for a little while? This article explores a trade designed to profit from that possibility.He followed up with:
The CBOE Implied Correlation Index got a lot of attention around the blogosphere and on Twitter last week, following Tuesday’s intraday spike to 103 and closing value above 80. Regular readers of my posts here are already familiar with the index, so I won’t delve into a thorough explanation except to mention the basic notion – that implied correlation tells us what the options markets are implying will be the degree to which stocks (in this case, the 50 largest S&P 500 components) move together as one. Just as implied volatility is an estimate of what future volatility will be, so implied correlation is a prediction about likely future movement of stocks together.
CBOE S&P 500 Implied Correlation Index. Source: thinkorswim
KCJ, the index of SPX component options expiring in January 2012, is not far from its all-time closing highs. Like volatility, implied correlation tends to revert lower toward a long-term mean once the cause of the high correlation dissipates. If we get some lasting clarity on the European sovereign debt situation, I expect KCJ to fall back to 65 or lower. How will that affect stocks and options? Well, we will see individual stocks and market sectors begin to move independently again – based on fundamentals, investor sentiment, and maybe even technicals.
I think a bet on declining correlation is a great move right now because the upside to implied correlation is limited and the downside is extensive. Think about it: stocks can only become socorrelated – there’s a natural ceiling at 1.00. My idea is to find a stock that has shown a lot of long-term independence from the S&P 500, but has acted like the index in recent weeks or months. Our trade will be to buy a straddle on the individual stock and sell a straddle on the index, on the expectation that correlation will decline during the life of the trade. A best-case scenario would be one in which the index doesn’t move very much but the individual stock moves a lot, generating time-decay gains for the short straddle and long-gamma gains for the long straddle. The worst case would be that the opposite happens (the index jumps in one direction and the stock goes nowhere), but that’s not likely to happen since we will be trading an issue that has already demonstrated a recent affinity for index-like behavior. If correlations stay high and both assets move together, our expected loss is nominal....MORE
More Thoughts on Dispersion
My recent column for TheStreet on unusually high equity correlations and a dispersion trade idea – “Trading the End of the Risk On/ Risk Off Environment” – was picked up over at CNBC’s NetNet (thanks, John!). I have a few more comments to add in response to reader feedback.
First, as I mentioned in the article, it’s definitely not optimal to limit the position to an index straddle and just one equity straddle. The more individual equities represented, the better, because that reduces the risk of any one or two stocks acting poorly and ruining the position. The larger the book, the more capital-intensive it is, and the more difficult it is to manage – but it also becomes a more accurate representation of the trade thesis....MORE
A $12bn dispersion trade
Och-Ziff Capital Management has just made a big trade — a $12bn dispersion one.I'll be back with more, in the meantime you may get a kick out of "Dispersion - A Guide for the Clueless".
It’s kind of a nifty way to bet on an end to QEased suppression of market volatility, at a time when traditional safe haven assets like gold and government bonds could be considered over-priced. The trade is this: almost $12bn of options, including $8.8bn of options on companies within the Standard & Poor’s 100 Index. The S&P options include both (bearish) puts and (bullish) calls, in almost equal measure. (Alright, if you want to be really specific, Och-Ziff reported $5.4bn of puts and $3.4bn of call options – making the position slightly more bearish.)...MORE
Dispersion - A Guide for the Clueless