Using Dispersion: A High Concept at a Low Cost

Active traders are facing a bit of a dilemma right now: The recent run-up makes people reluctant to buy or chase stocks at new 52-week highs. But it's also a tough place to be short. Neither side engenders what I call two-handed confidence.

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.