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Options Pros Consider Play on Indices' Divergence

Volatilities in the Dow and the S&P are going separate ways, but some say the arb opportunity isn't a real-world trade.

If you think the

Dow Jones Industrial Average

and the

S&P 500

indices fly in tandem, it may be time to bet against that historical relationship using index options.

On paper, it could be. In reality, it may not be that simple.

For a few reasons, the volatilities of the Dow and the S&P are continuing to diverge, said Leon Gross, institutional strategist for

Salomon Smith Barney


"We think the S&P is getting more volatile because it has a much higher proportion of technology stocks, and the Dow doesn't. If you look at the S&P, its biggest stocks are technology-related, and the sensitivity of the S&P to the


is increasing over time," Gross said. "As more technology stocks are added to the S&P -- perhaps



as one example -- and not to the Dow, the S&P volatility increases. With the Dow, that's not happening," but the S&P and Dow options aren't accounting for that.

And there's a way to make money on that divergence and "take advantage of the mispricing between the S&P and Dow indices and get a sort of free option on technology stock movement," Gross said, elaborating on a recent piece of his firm's research.

The "realized," or actual, volatility in the Dow has steadily declined in comparison with the S&P since the market began to recover in November 1998, even though the implied volatility priced into the options has remained pretty much the same.

This kind of information can provide a clue to options players. An index option buyer using the position to hedge a portfolio can take advantage of this discrepancy via various trading strategies. A directional investor can express a bullish view on the market with a short put on the Dow index option, while a bearish investor can express it through a short call.

In other words, the market is mistakenly pricing these two index options the same, even though the S&P 500's recent volatility was 3.5 percentage points higher than the Dow.

Salomon's Gross pointed out that the S&P volatility is growing more akin to the

Nasdaq 100

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than to the Dow. In the second quarter of 1998, the S&P was sensitive to the Dow 77.7% of the time, a reading that has fallen to about 60% thus far in 1999. Meanwhile, the S&P's sensitivity to the tech-laden Nasdaq for the same periods rose to 27% from 17%.

Moreover, Salomon contends, looking forward, S&P volatility will continue to outstrip that of the Dow, in part because of recent and upcoming splits of


(T) - Get AT&T Inc. Report



(WMT) - Get Walmart Inc. Report



(IBM) - Get International Business Machines (IBM) Report



(C) - Get Citigroup Inc. Report


AT&T and Wal-Mart recently split, while IBM and Citigroup are expected to split within the next month. Because the Dow is a price-weighted index, rather than a market-weighted index like the S&P, that will further split the volatilities between the Dow and S&P, the report contends.

Whether investors actually trade on such divergences is another issue. Greg Simmons, an index options trader and head of

Linear Capital Partners

in California, said he wouldn't consider this arbitrage opportunity with a real-world trade.

"That historical relationship

between the S&P and the Dow has been thrown in the trash for ages now. The other day, for example, the Dow closed up after the S&P was still down 7. So the Dow and S&P's relationship has decoupled," Simmons said. "But frankly, the Dow options aren't such a useful vehicle; the S&P 500 are the only thing that's really pure. For institutions, it's the only product that's deep enough and liquid enough."

Simmons conceded that the relationship is "skewed" but doubts whether it is a worthwhile play. "They're trading on assumptions and noncorrelated assets. Whether it works or not, it's a gamble," he said. "It's not a sure thing. It lends too much risk that all the ducks do or don't line up. It's simply too risky."