Sophisticated option volatility strategies are frequently employed by experienced traders. One such strategy is dispersion trading. In this blog, we will dissect a modified form of the dispersion trade to make it easy even for beginners.
What is Dispersion Trading?
The trade known as a dispersion trade is quite complex and is primarily applied by professionals who deal with options relating to the index as well as its components. Here’s how it works:
Correlation Bets
In a standard dispersion trade, traders executing dispersion trades might sell calls on an index (e.g., Nifty Index) while simultaneously buying call options on individual stocks that make up the index. The essence of this strategy is a bet on the dispersion of returns among the index components, meaning the trader expects the correlation among the returns of the index constituents to be low.
How Does It Work?
If the correlation among the stocks in the index is low, some stocks will perform better than others. While the Nifty index itself might not move significantly (as the gains and losses within its components balance each other out), the options on the individual stocks will react more strongly. This is because of the concept of “gamma” in options trading:
Gamma: It measures how fast an option’s delta changes when a given security price changes. Gamma for at-the-money (ATM) options is higher implying that small movements in the stock price can result in great shifts in the delta of an option leading to bigger profits or smaller losses.
Usually, dispersion trades are structured as delta-neutral trades where the initial delta (sensitivity to spot asset price) equals zero. The aim is to profit from the realized correlations among the index constituents being lower than the correlations implied by the option prices.
Modified Dispersion Trade for Retail Traders
Retail traders cannot usually execute a classic dispersion trade due to the large amount of capital required and complex mathematical models. However, there is a simplified version that can be used:
How to Set Up the Trade
- Short a Call on the Nifty Index: This means you sell a call option on the Nifty Index.
- Long Calls on Selected Stocks: Buy call options on one or two stocks within the index that you expect to outperform.
Objectives and Expectations
The strategy here is to gain from the positive delta and gamma of calls on those out-performing stocks as well as the time decay (theta) in the short call of the index. Unlike bull call spread where you short an out-of-money strike price on the same underlying index betting it will not surpass some resistance level; modified dispersion trade is a bet against relative outperformance by some index constituents to the overall index.
Key Considerations
- Higher Realized Correlation During Crashes: Dispersion trades can incur significant losses during market crashes because correlations among all traded stocks tend to increase.
- Empirical Evidence: Historically, correlations implied by index option prices and equity option prices have been higher than actual average realized correlations among underlying stocks. These divergences provide encouragement for institutional investors to pursue dispersion trades intended to profit from them.
Conclusion
While classic dispersion trades might be difficult for many individual traders, understanding and possibly using such altered versions may still present unique opportunities. With careful selection of stocks expected to perform better while utilizing characteristics of options available, retail traders can implement a strategy consistent with principles underlying dispersion trade. This strategy has risks which should be approached with caution, particularly amidst volatile markets, and must be based upon sound analysis always.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
