Steven Smith

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Using Dispersion: A High Concept at a Low Cost

Steven Smith

That's why option traders like to take advantage of their ability to swing both ways. We can be long and short simultaneously by using a dispersion trade.

Volatility dispersion trading 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.

Sum of the Parts

By definition, an index is a portfolio, which in theory should be less risky than an individual stock. A portfolio dilutes company-specific risk and is only subject to market risk, while 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 the index options and buy options on the individual components.

"Creating offsetting positions between an index and its components is fairly straightforward and easy to calculate. It is also a strategy that, through market efficiency and the sophistication of the participants, has been 'arbed' to death, leaving only marginal profit potential," says Robert Brett, a partner at Brett & Higgins, a New York-based hedge fund.

But strategies can become quite numerous and labor-intensive with traders looking at implied vs. historical measures on the indices and the individual components: implied correlation, equivalency weightings, stock-specific variances, contributions to the index as well as hedging techniques on each individual component to keep everything in balance.

Hedge funds have a market-neutral mandate, large sums of money and the resources to crunch the numbers and find small statistical advantages that they can use to execute in large numbers at low costs. But for a majority of investors, the capital requirements and commission fees that accompany these strategies, which can require many separate transactions, are unrealistic and unprofitable. While I really don't like to go out to row 1,282, column ZZZ, on an Excel spreadsheet to lock in a nickel, we can still apply the underlying theories to create a stripped-down version of a dispersion strategy. We'll use common sense instead of a supercomputer.

A Semi-Dispersion Position

The Philadelphia Semiconductor Index and the Semiconductor HOLDRs Trust(SMH Quote) have climbed 33% and 42%, respectively, since their March lows. Recently there has been a flurry of put-buying as investors look to protect those gains.

While this may seem prudent, especially as we head into earnings season; the outright purchase of puts can be quite costly and often an ineffective form of insurance. But using dispersion can establish a low-cost hedge. I'm going to use SMH put options rather than those on the SOX, because SMH options are more liquid and, with the underlying Exchange Traded Fund trading in the $30 range vs. the SOX's $400 price, less expensive.

Some vs. All

The table below illustrates a possible position, prices and values involved in selling five near-the-money SMH puts while simultaneously buying puts on three of the components, Teradyne(TER Quote), KLA-Tencor(KLAC Quote) and Novellus(NVLS Quote).

Prices are based on Tuesday's close.

SMH Dispersion
Stock (Symbol) Price	Option Position	Net Debit/Credit
SemiHolders (SMH) $31.50	Short 5 Aug 32.50 Puts $2	$1000
Teradyne (TER) $19.15	Long 1 Aug 17.50 Put $0.80	(0.80)
Novellus (NVLS) $38.40	Long 1 Aug 37.50 Put $2.10	(210)
KLA-Tencor (KLAC) $50.20	Long 1 Aug $50 Call $2.30	(230)
Net		480
Source: TSC Research

The Payoff

The sector is basically pricing in positive earnings and an optimistic second-half outlook. If this holds true, the group as a whole should rise, taking the short SMH puts out of the money, rendering them worthless. The position would most likely be a scratch or even yield a moderate profit of $480, or the net credit premium. Any existing long shares of underlying stocks will be poised to rack up further gains.

Given the stock basket dynamics and the fact that the three stocks in the example represent just 5.8% of SMH's composition, a decline by one of the stocks should translate into a smaller percentage move in the basket at large. There's an opportunity for profit if an individual issue declines by a greater magnitude than SMH itself. This could occur if one issues a warning or has bad company-specific news instead of a problem plaguing the entire sector.

A danger for the position would be if one of the three stocks with the largest weighting, Intel(INTC Quote), Texas Instruments (TXN Quote) or Applied Materials (AMAT Quote), which together represent 47% of SMH, were to stumble, causing the ETF to drop significantly more than one of our three protected issues.

Construct a position that best matches your existing portfolio and most accurately reflects your market opinion and outlook. You may gain more downside protection by buying puts on a different or larger group of individual issues.