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Options Strategy: Exploit the Correlation Crush

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In a recent piece, I discussed the use of a paired options trade strategy to capitalize on a decline in correlations in 2014.

Correlation refers to assets, sometimes in very different classes, moving up and down at the same time.

Today, I want to look at the concept of dispersion.

With paired trades, we used options to reduce capital requirements and increase leverage provided to improve the risk/reward profile.

Dispersion refers to how much more or less the individual components within a broader group (like an index) will move relative to the whole. Here, the application of options is more tightly embedded in the strategy itself; namely, leveraging the differential of volatilities between the individual stocks and the total index they comprise.

In a world of lower correlation, there should be higher dispersion.

Both benefit investors with superior stock picking skills.

Sum of the Parts

By definition, an index is a portfolio of many singular components which in theory should be less risky than an individual stock. A portfolio dilutes company-specific risk and is mostly subject to market risk.

An individual stock is exposed to both risks, which are typically priced into the average stock option. This is why dispersion strategies typically look to short index options and buy options on individual components.

A volatility dispersion trade is a popular hedged strategy designed to take advantage of relative value differences in volatilities between an index and a basket of the component stocks. This would allow one to take advantage of large price moves without incurring exposure to changes in implied volatility, or vega risk. Vega measures the expected change in dollar value of an option for each unit change in implied volatility.

A strict application of a volatility dispersion strategy is not practical for an individual investor. It requires high levels of computing power to crunch data such implied vs. historical measures of both the indices and the individual components, implied correlation, equivalency weightings, stock-specific variances, and contributions to the index to find small statistical advantages they can execute in large numbers at low costs. It also is labor intensive in that it requires ongoing adjustments to keep everything in balance.

Large hedge funds might be able to do this, but going out to row 1,282, column ZZZ, on a spreadsheet to lock in a nickel doesn't sound like much fun me.

However, we can still apply the underlying concept to create a stripped-down version of a dispersion strategy. We'll use common sense instead of a supercomputer.

Sector ETFs Provide Right Vehicle

Thanks to their focused nature and liquidity, sector exchange-traded funds (ETFs) offer a good vehicle for applying a dispersion strategy.

It allows one to sell options on the lower volatility index and buy volatility a handful of individual names.

Let's use the SPDR Retail (NYSEARCA:XRT) to drill into how an "everyman" dispersion could be implemented.

The retail sector has gone from hero to zero as high holiday hopes were dashed by the dismal final sales numbers. Logistical issues impacted United Parcel (NYSEARCA:UPS), promotional pricing hurt Best Buy (NYSEARCA:BBY), hacking swiped sales away from Target (NYSE:TGT), and msot recently, Wal-Mart (NYSE:WMT) said the expiration of extended unemployment benefits is hurting sales.

On top of this, the record frigid weather has cast a general freeze on consumer spending. Even the mighty Amazon (NASDAQ:AMZN) came up short on whatever opaque numbers they fed to analysts.

The XRT, which was up 42% in 2013, is down 11% in 2014.

Note, most of the individual names mentioned above did even better in 2013 before turning down to underperform. The corresponding higher betas relative to the index can be seen in volatility levels.

Not surprisingly, the XRT has seen both realized and implied volatility climb in recent weeks.

But not nearly as much as Target, whose shares have declined some 15% year-to-date:

Or Best Buy, which has tumbled over 20%, and saw HV and IV move up some 30% to the 100% and 70% levels respectively.

In a dispersion strategy, if one had sold strangles or strangles in the XRT (sold both puts and calls), and used the proceeds to buy individual names, the trade would have been profitable in both the up market of 2013 and the decline in 2014.

Leaning Towards a Rally

My approach is to buy calls in three retailers that I think are either oversold and ready to bounce back, or those doing well that should continue to outperform.

Against my limited basket, I want to offset the cost of the trade by selling call premium in the XRT.

For example I would buy calls in:

1) Nike (NYSE:NKE), which has sold off, but still has implied volatility readings near 52-year lows. One of the big winners in retail has been Under Armour (NYSE:UA), which jumped some 20% following strong earnings. While UA has less overseas (Asian ) exposure, I think its good news still bodes well for Nike with the upcoming Olympics and World Cup.

2) Home Depot (NYSE:HD) shares are also down some 7% year-to-date and near support at the $74 level. Interest rates are heading back down, homebuilders have reported mostly positive earnings and guidance, and once the weather eventually turns, there will be pent-up demand for more home improvement goods and services.

3) As mentioned, shares of Target (NYSE:TGT) have been pummeled for a variety of reasons. It is now deeply oversold. The risk/reward near the $55 is attractive as that I a potential double bottom at the 2012 low.

I would buy calls with an April expiration that are 5% out-of-the-money in each of these three names. Against that, I would sell XRT calls that expire in March that are also 5% out-of-the-money.

The reason for selling nearer-term calls is to take advantage of the acceleration of time decay. The premium collected will help offset the cost of the calls purchased.

Remember to construct the position based on a delta basis or share equivalent basis, not notional values or dollar amounts. These concepts were covered in my recent article on stock replacement strategies.

If retail stocks continue to crater, the loss will be limited. If the market rebounds, and the stocks we chose outperform, this dispersion will deliver handsome profits.

Steve Smith's OptionSmith portfolio was up 43% in 2013. Take a FREE 14 day trial to get exclusive access to the portfolio and Steve's top trading ideas. Learn more now.
POSITION:  No positions in stocks mentioned.