Variance Dispersion and Correlation Trading

Dispersion trade: trading an index volatility vs the volatility of a basket of stocks. 

 

Index variance < average variance of constituents --> diversification effect --> related to correlation between constituents. 

 

Back-testing --> IV-RV premium of index > IV-RV premium of single-stock. 

Selling variance on an index and buying variance on its members has generally been a profitable strategy. 

This can be partly explained by demand for protection at the index level. 

 

Realised index volatility can be thought of as arising from two factors:

(a) the volatilities of the constituents.

(b) the correlation between them. 

 

Realised index variance is described by the equation: Dispersion 2

These realised quantities can be observed and pairwise correls calculated and averaged to give overall correlation for index. 

 

Another way to express this ‘average correlation’ --> assume that correlation is the same for all pairs of stocks. 

Disp 5    or approximately (for a well diversified index): Disp 6

 

Advantage: average implied correlation (not directly measurable) can be backed out from IV of index and constituents. 

 

This implied correlation can be traded by selling index variance and buying single-stock variance --> short correl. 

To hedge out the exposure to volatility initially --> legs must be weighted with more index Nvega than single-stock Nvega

The Nvega of the constituents must be adjusted by a factor equal to the square root of implied correlation. 

 

Like volatility, implied correlation > realised correlation  --> candidate for carry-style trades. 

Rolling short correlation through variance dispersion performs well on average. 

 

Volatility and correlation are themselves correlated --> tend to spike together in a sharp sell-off.

 

Variance dispersion trade = short correlation

- losses can be very large as the trade becomes short volatility when both correlation and volatily go up. 

- gains are diminished as the trade becomes long volatility when both volatility and correlation go down. 

 

This ‘volatility-scaling effect’ helps to account for the premium of variance dispersion levels compared to correl swaps. 

 

Equity correlation can also be traded more directly through correlation swaps.

For technical reasons, correl swaps levels tend to trade below the levels of correl associated with variance dispersion trades. 

By dynamically trading vega-neutral variance dispersions until maturity --> almost replicate the payoff of a correl swap. 

 

Add a comment

 

The NEW website is OUT! 

Go have a look at https://www.derivativesacademy.com.

You will find the content in the 'Derivatives Academy' section in a book format. 
The full content is not yet available as I am rewriting it and improving it.

You can try the Exotic Derivatives pricer under the 'Derivatives Pricer' section (
https://www.derivativesacademy.com/derivatives-pricer/). I will speed up the page soon as I forgot to compress some images.
Each application allows you to price differents products and contains links towards the correct section of the book. 
You will then be able to get practical and theoretical knowledge quite easily.

I teach quite often using the pricer. You can get so much information and answers to your questions thanks to it.

Take advantage of it as much as you can to hone your knowledge!

If you are looking for junior opportunities in the field of market finance. Register yourself on the website. It's free!

If you have any questions, do not hesitate to contact me on info@derivativesacademy.com.