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.
- The story goes that in the old days, traders with enough capital to sling around would regularly trade dispersion/correlation on a speculative basis. You don’t hear about that so much any more, although, as I told Bloomberg earlier this year, Och-Ziff seems to have been making big bets on this front (more from FT). They were early, and wrong, but notice that their third quarter earnings miss last week was caused – they claim – by higher taxes rather than trading losses.
- I only like this as a large-scale, world-historical bet on the shape of things to come. Or in less Hegelian terms, I like a dispersion trade when stocks with average correlations to SPX of 0.10 – 0.50 have been moving to the tune of 0.90 or more. Has this sort of dislocation happened often in history? I wonder. With a sufficiently large book and a reasonable time frame, the upside on a return to average correlations looks huge, and if there is a sizable downside risk, I don’t see it.
- This is one of those times when managing assets as a commodity trading advisor isn’t an ideal fit. Neither would a traditional RIA have the wherewithal to follow up on a thesis like this. Sometimes, for the really interesting trades with a tantalizing risk profile, you need to be in a hedge fund.
- I’m also looking at correlation and implied correlation among asset classes. Everyone was alarmed earlier this year when gold started behaving like a risk asset, moving more in sync with equities. That phase appears to be over, but I’m curious whether currencies and commodities are moving in line with long-term patterns.
- If you really want to geek out, this paper looks interesting: Variance Dispersion and Correlation Swaps. I spoke with someone at the CBOE a year or two ago who mentioned they were toying with the idea of exchange-traded correlation swaps. Given the total lack of volume in the CFE’s variance swap futures, I doubt whether a correlation product would get any love. All the good products die young.