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Minyan Mailbag: Volatility and Correlation

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Editor's Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Professor Succo,

Firstly, I'd like to say that you make a great point on the
difference between systematic and individual issue vol. Indeed my fellow Minyans may be interested to know, if they're not already aware of this, that people make a living (albeit not much of a living of late) trading correlation through dispersion strategies.

Effectively what a dispersion trader is doing is trading the volatility of an index against the volatility of its components. Dispersion was a nicely profitable strategy until quite recently for a number of structural reasons (such as the higher number of individual issue gamma sellers relative to systematic gamma sellers, institutional demand for protection through index options and so on) which manifested themselves through realized correlation trading, on average, above implied correlation effectively creating (in Wall Street if not Merriam Webster terms) an arbitrage opportunity. Unfortunately for those trying to implement dispersion strategies, the spread between implied and realized correlation has diminished over time. The consensus at the moment, at least among the people I speak to, is that dispersion has been arbed to death. For what it's worth, I tend to think that this diminution of opportunity is more a result of a combination of both structural and cyclical factors than the exclusively structural reasons commonly given. I would be very interested to hear what you have to say about the viability of dispersion strategies going forward. I'm sure you can also do a much better job of explaining dispersion trading than me, if you feel so inclined of course.

It's worth noting that implied dispersion is highly correlated with implied index vol, so although there are a number of reasons for institutions to run dispersion books, for most operations it's easier just to trade index vol.

Secondly, in
your article on the 23rd of June 2005 you state that the Black Scholes option valuation model was derived from the mathematics of fluid dynamics. Fluid dynamics is certainly commonly used in derivatives pricing, but I was under the impression, and I may be wrong on this, that BS73 was derived from the famous partial differential equation of heat transfer.

Finally, I just wanted to tell you how great it is to have someone providing a real-time education on the ins and outs of the options business. It's certainly refreshing to see options trading talked about as it is actually done, in real time no less, rather than just how it is according to theory statically in a book. That's not to diminish theory, it's certainly very important. But I think this emphasis on the practical aspects of trading is an area where the practitioner/writer model of Minyanville really pays off.

By the way, 'Volatility and Correlation' is also the name of an excellent book by Riccardo Rebonato (2nd edition, Wiley 2004). If you have a chance I'd definitely recommend that you take a look, if you haven't done so already.

With thanks,
Minyan Michael

Michael,

You do a great job of explaining dispersion trading.

We trade dispersion opportunistically. We have other strategies where we look for opportunities when there are none in dispersion. As you correctly point out, dispersion opportunities are highly correlated to the actual level of volatility in index options, although a further comment that that increased volatility needs to be caused predominately by increased correlation rather than increased component volatility.

The last time we sold an index option was February of 2004 when correlations rose to our target level. We covered those index options in November 2004 and have not sold any since.

Regards,
Prof. Succo

No positions in stocks mentioned.

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