This blog post is a re-factored version of this Twitter thread
Let’s do dispersion trading for the uninitiated.
The stocks move exactly together in a big way.
You win on your stock straddles but you will lose more on your index short.
Why?
The index is cheaper than the sum of the legs in straddle space. To understand why, we will need some simple math.
Correlation represents the spread between an index’s vol and the vol of the components.
The equation:
Here’s index vol relation to corr for a fixed stock vol of 30%
If you structure a trade vega neutral or premium neutral you will be short correlation convexity.
If you put the 3D options glasses on, you’ll notice that correlation has its own surface!
Implied correlation surfaces vary across sectors as well. Energy, biotech, bank etfs. The sector indices have implied correlations between basket components.
Then consider FX vol markets. They care about the rate vols of the individual fiat legs and, you guessed it, the correlation.
How about a US investor trading options on a foreign index of an exporter nation. Like Japan. There’s an implied correlation between the yen and the equity index itself. Google the term quanto if you want to explore that idea.
The risk for any portfolio of long/short trades (either delta one or volatility) is as correlations increase your gross positions become exposed. You can’t hide behind “nets” when corrs explode higher. This is especially dangerous because most “hedged” portfolios are levered.
Imagine a beta neutral trade where you are long 2 units of “alpha stock” and short 1 unit of index (assume they are the same vol, but “alpha” stock is .50 corr).
How do implied correlations correlate to systematic risk premia? How do they compare to realized corrs?These types of questions are the start of seeing the world as one big spiderweb of risk premia and cross correlations.
Armed with this understanding, go build the dashboard to find the cheapest hedges, the most efficient basis, or the most levered shot at correlation regimes shifting. In other words, you don’t have to have a view on whether assets are cheap or not. You can look for situations where implied correlations are [over]confident in particular regimes persisting.
If you use options to hedge or invest, check out the moontower.ai option trading analytics platform
Know-Nothing Sizing We’ve been talking about how the market does follow the fundamentals you are…
Friends, I published a new resource: The Essential Paul Graham (Moontower reading guide) Description Paul Graham…
When a friend asks me what I think of investing in the SP500 I have…
Friends, I saw this chart on LinkedIn and the call of mental math immediately lured…
Friends, I saw this chart on LinkedIn and the call of mental math immediately lured…
My recent post, Nah…you just ain’t seein’ the ball addresses the lazy confession you hear when professional…