Experienced traders initiate advanced strategies relating to option volatility. This week, we discuss a modified version of one such strategy called dispersion trade.

Correlation bets

Consider a typical dispersion trade on an index. This could be, say, a short call on the Nifty Index and long calls on the index components. This trade is a bet on the dispersion in the returns of the index components. That is, it is bet that the correlation among returns of the index constituents will be low. How will the setup gain from the bet?

Low correlation means that some constituents in the index will perform better than the others. The Nifty Index will not move much because the losses in some stocks will drag the gains in others. Therefore, the Nifty Index option may not move much. That will not be the case with equity options — options on individual stocks that constitute the index. Assuming an institution buys at-the-money (ATM) strikes, the gains on call options on stocks that rise in price ought to be more than the losses on call options on stocks that do not perform well. This is because of the high positive gamma of the ATM calls. That is, the gamma (which captures the change in option delta) increases the delta when an underlying moves up, but reduces the delta when the underlying declines. Typically, the strategy is setup as a delta-neutral trade. The bet is that the realised correlations among the index constituents are less than the correlations implied in the equity option prices.

Now, of course, retail traders cannot set up such a dispersion trade as it involves large capital outlay, not to mention applying mathematical models to understand implied correlations. But what about a modified version of the trade? That is, you short a call on the Nifty Index and go long on call option on one or two stocks that constitute the index. You must pick stocks that are expected to outperform the index. The idea is to gain from positive delta (and gamma) of the calls on the outperforming stocks and from implied volatility on the index option through its time decay.

This trade has a different objective compared with a bull call spread where you short an out-of-the-money strike on the same underlying; the bet is that the underlying is unlikely to move past an overhead resistance level. A modified dispersion trade is a relative bet — that some constituents will outperform the index.

Take note
Correlations implied by index option price and equity option prices have been typically higher than the average realised correlation of the underlying constituents
Optional reading

Empirically, correlations implied by index option price and equity option prices have been typically higher than the average realised correlation of the underlying constituents. Hence the motivation for institutions to set up the classic dispersion trade. Note that the strategy will incur large losses when markets crash. This is because a dispersion trade is a bet that the correlation among the index constituents will be low. But correlation between all traded assets tends be high during market crashes.

The author offers training programmes for individuals to manage their personal investments

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