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.
  • 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.

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2 Comments For This Post

  1. Geoff31858 Says:

    Jared…. I’m new to your site (I followed a link here from Derek Hernquist’s recent blog post.) I find your trade thinking here terribly interesting, however. I also use TOS as a platform and was looking at the risk profile of this dispersion trade idea under the TOS “analyse” tab and, frankly, it comes up looking similar to simply buying a single OXY straddle. Prices have shifted, of course, since you wrote this article, so I tried to adjust. In the end, however, the theta is still negative and I’m having a hard time understanding how this trade would work. What Am I not getting? If SPY and OXY fell out of correlation (as hoped) then what would this trade look like? Thanks. Geoff

  2. Jared Says:

    Hi Geoff,

    Thanks for your comment. I wouldn’t trust a thinkorswim risk profile for this sort of trade, for a few reasons. One reason is that if we set the profile to the portfolio level and look at the SPY-beta-weighted profile of the position, no matter what the profile looks like, we will be ignoring the thesis of the trade. If the thesis involves a change in the correlation of SPY and OXY over the next few months, taking long-run estimates of the beta of OXY to SPY into account to generate a risk estimate means we’re either assuming our conclusion (if recent beta has been higher than the long-run average) or assuming its negation (if vice versa). Another problem is that the Analyze tab doesn’t give us any way to estimate changes in implied vol in the two assets, or to do so conditional on price level.

    Theta is slightly negative, but these risk measures are dominated by delta and correlation in this case.

    Per your question about how things would look in the ideal outcome: we would see SPY move very little such that the short straddle would expire worthless and OXY would move very much, generating a large profit on the long straddle. A much more likely outcome is that both assets tend to be somewhat correlated but that OXY moves more than expected and SPY moves less – the position is vega neutral so as long as OXY remains a higher beta asset, the downside risk should be limited.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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