Trading index versus single-stock volatility
Question
What is dispersion trading?
Short answer
It is a correlation trade: typically selling volatility on an index while buying volatility on its constituents (or the reverse). Index variance is roughly the weighted constituent variances plus correlation terms, and index options often imply higher correlation than is realised. Short index, long components profits if realised correlation is low, i.e. stocks disperse; it loses when correlations spike in a selloff.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 37, p.176; question and answer rewritten by SelfMadeQuant.com.
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- Reading the Implied Vol Surface — Moneyness, Term Structure, and Quoting Conventions
- Covariance and Correlation
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