Correlation and Dispersion Trading Discussion at CBOE RMC Conference

One of the final sessions of the day teamed up Daniel Danon, Senior Vice President, Portfolio Management and Structuring at Assenagon Asset Management and Tim Edwards, Director of Index Investment Strategy at S&P Dow Jones Indices. Their presentation was titled Correlation and Dispersion: What They Mean and How to Trading Them.

Tim Edwards began the presentation stating that many correlation traders are actually acting a dispersion traders.   He notes that dispersion is a measure of the spread of performances among components of an index or portfolio. He showed a chart depicting dispersion of returns for the components of the S&P 500. Like volatility dispersion is a range bound and mean reverting measure. Both dispersion and volatility are highly correlated, but do have some differences. For instance in August 2011 there was low dispersion but high volatility in the markets.

While discussing dispersion he brings up the phrase “stock pickers market”. This is generally thought of as market components having low correlation. The feeling is this is not the correct way to think of a stock picker’s market. Return available from security selection is more naturally associated with dispersion. He followed on this thought by showing that “good” managers outperform when dispersion is high. Also, he points out that dispersion is directly connected to the degree of diversification achieved by a portfolio.

Dan Danon took over from Tim and showed some examples of how to go about trading dispersion. He states that the standard dispersion strategy involves trading index volatility versus the volatility of its components. He cites the Volatility Pair Index (VPI) which is a measure of implied volatility over 150 stocks worldwide minus the average implied volatility over 5 main stock indexes worldwide. An interesting historical example that Danon noted was based on the fiscal cliff situation at the end of 2013. He said that traders were focused on market volatility and bid up VIX while individual stock volatility was not impacted by this potential pending event. This created an opportunity to short index volatility and buy individual stock volatility.

Three methods of investing in dispersion were mentioned – using individual options, variance swaps, or volatility swaps. His firm is using options to implement their outlook. He notes that he is able to easily actively manage their position due to listed options being liquid and the pricing transparent. The next step beyond a basic dispersion trade which may also be thought of as a pair trade is to what he calls a selective dispersion trade.  This method involves more active management and again lends itself to using listed options to implement the strategy.

A good resource to learn a little more about dispersion trading can be found at –

http://us.spindices.com/documents/research/research-dispersion-measuring-market-opportunity.pdf