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Dispersion Trades: Playing to Win

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Assessing their value in today's market.

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A commenter the other day brought an interesting academic study to my attention.

In the latest issue of the Journal of Finance, there's an interesting article entitled "The Price of Correlation Risk: Evidence from Equity Options," by Driessen, Maenhout and Vilkov, of the University of Amsterdam, in which they show evidence that:

1. Options on indexes (e.g. S&P 100) and options on individual stocks behave differently;

2. Options on indexes (e.g. S&P 100) are relatively expensive and earn low returns when compared to options on individual stocks;

3. The previously known fact in the literature that from Jan '96 to Jan '04, the Implied Volatility (IV) (calculated using the Black-Scholes equation) of S&P 100 index options was significantly higher than the realized volatility (RV). So, in that sense, index options were significantly overpriced. On the other hand (over the same time span), the cross-sectional average of the IV was not significantly different from the RV for the individual stocks of the S&P 100 index, showing the options on the individual stocks of the S&P 100 index were much more correctly priced (than the index options).

4. The differential pricing of index and individual stock options can be attributed to the risk that the stocks comprising the index may become highly correlated, and hence that the index investor may not obtain the desired diversification. The authors propose that traders are overly cautious about correlation risk, which leads them to an irrationally high premium for the index options. (It's been known that correlations between stock returns increase when returns are low, which affects investor welfare by lowering diversification benefits and increasing market volatility.)

5. A simple-based trading strategy can exploit this. The strategy they derive sells index straddles and buys individual stock and individual straddles. This trading strategy is shown to have an excess returns of 10% per month (compared to trading the market index) and a large risk-adjusted (Sharpe ratio) 77% higher.

Basically, this refers to the dispersion play, where you go long gamma in individual names and go short it on an underlying index and ETF. It's essentially a bet on the correlation of the stocks you play. If correlation stays low -- i.e., your stocks have a mind of their own -- you win. And sometimes big, if you get lots of gaps.

Best I can tell from this blurb, the authors statistically "prove" the play works, with the added twist that you should go long stock, too.
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No positions in stocks mentioned.
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