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The high difference between implied volatility of index options and subsequent realized volatility is a dispersion trade option fact. Trades routinely exploit this difference by selling options with consecutive delta hedging. There is however more elegant way to exploit this risk premium - the dispersion trading.
The dispersion trading uses known fact that difference between implied and realized volatility is greater between index options than between individual stock option. Investor therefore could sell options on index and buy individual stocks options. Dispersion trading is a sort of correlation trading as trades are usually profitable in a time when the individual stocks are not strongly correlated and losses money during stress periods when correlation rises.
Basic trade could be enhanced by buying options of firms with high belief disagreement high analysts' disagreement about firms' earnings. Research shows that option excess returns reflect the different exposure to disagreement risk.
Investors who buy options of firms which are more prone to heterogeneity in beliefs are compensated in equilibrium for holding this risk.
Volatility risk premia of individual and index options represent compensation for the priced disagreement risk. Hence, in the cross-section of dispersion trade option the volatility risk premium depends on the size of belief heterogeneity of this particular firm and the business cycle indicator.
Trading vehicle are options on stocks from this index and also options on index itself. Each month, investor sorts stocks dispersion trade option into quintiles based on the size of belief disagreement. He buys stocks with the highest belief disagreement and sells the index put is an equally-weighted portfol io of 1-month index put options with Black-Scholes deltas ranging from Writers of index options earn high returns due to a significant and high volatility risk premium, but writers of options in single-stock markets earn lower returns.
The wedge between the index and individual volatility risk premium is mainly driven by a correlation risk premium which emerges endogenously due to the following model features: In equilibrium, the skewness of the individual stocks and the index differ due to a correlation risk premium. Depending on the share of the firm in dispersion trade option aggregate market, and the size of the disagreement about the business cycle, the skewness of the index can be larger in absolute values or smaller than the one of individual stocks.
As a consequence, the volatility risk premium of the index is larger or smaller than the individual. In equilibrium, this different exposure to disagreement risk is compensated in the cross-section of options and model-implied trading strategies exploiting differences in disagreement earn substantial excess returns. Sorting stocks based on differences in beliefs, we find that volatility trading strategies dispersion trade option different exposures to disagreement risk in the cross-section of options earn high Sharpe ratios.
The results are robust to different standard dispersion trade option variables and transaction costs and are not subsumed by other theories explaining the volatility risk premia. Motivated by extensive evidence that stock-return correlations are stochastic, we analyze whether the risk of correlation dispersion trade option affecting diversification benefits may be priced. We propose a direct and intuitive test by comparing option-implied correlations between stock returns obtained by combining index option prices with prices of options on all index components with realized correlations.
Our parsimonious model shows that the dispersion trade option gap between average implied Empirical implementation of our model also indicates that the index variance risk premium can be attributed to the high price of correlation risk. Finally, we provide evidence that option-implied correlations have remarkable predictive power for future stock market returns, which also stays significant after controlling for a number of fundamental market return predictors.
Dispersion Trading in German Option Market http: There has been an increasing variety of volatility related trading strategies developed since the publication of Black-Scholes-Merton study.
In this paper we study one of dispersion trading strategies, which attempts to profit from mispricing of the dispersion trade option volatility of the index compared to implied volatilities of its individual constituents. Although the primary goal of this study is to find whether there were any profitable trading opportunities from November 3, through May 10, in the German option market, it is also interesting to check whether broadly documented stylized fact that implied volatility of the index on dispersion trade option tends to be larger than theoretical volatility of the index calculated using implied volatilities of its components Driessen, Maenhout and Vilkov and others still holds in times of extreme volatility and correlation that we could dispersion trade option in the study period.
Also we touch the issue of what is or was causing this discrepancy. Studying the properties of the correlation dispersion trade option http: This thesis tries dispersion trade option explore the profitability of the dispersion trading strategies.
We begin examining the different methods proposed to price variance swaps. We have developed a model that explains why dispersion trade option dispersion trading arises and what the main drivers are. After a description of our model, we implement a dispersion trading in the EuroStoxx We analyze the profile of a systematic short strategy of a variance swap on this index while being long the constituents. We show that there is sense in selling correlation on short-term. We also discuss the timing of the strategy and future developments and improvements.
My first task was to develop an analysis of the performances of the funds on hidden assets where the team's dispersion trade option focus was on, such as Volatility Swap, Variance Swap, Correlation Swap, Covariance Swap, Absolute Dispersion, Call on Absolute Dispersion Palladium. The purpose was to anticipate the profit and to know when and how to reallocate assets according to the market conditions. Secondly, I had a research project on Correlation trades especially involving Correlation Swaps and Dispersion Trades.
This report is to summarize the research I have conducted in this subject. Lyxor has been benefiting from taking short positions on Dispersion Trades through variance dispersion trade option, thanks dispersion trade option the fact that empirically the index variance trades rich with respect to the variance of the components. However, a short position on a dispersion trade being equivalent to taking a long position in correlation, in case of a market crash or a volatility spikewe can have a loss in the position.
Thus, the goal of the research was to find an effective hedging strategy that can protect the fund under unfavorable market conditions. The main idea was to apply the fact that dispersion trades and correlation swaps are both ways to have exposure on correlation, dispersion trade option with dispersion trade option risk factors.
While correlation swap has a pure exposure to correlation, dispersion trade has exposure to the realised volatilities as dispersion trade option as the correlation of the components. Thus, having risk to another factor, the implied correlation of a dispersion trade is above empirically, 10 points the strike of the equivalent correlation swap. Thus, taking these two products and taking opposite positions in the two, we try to achieve a hedging effect.
Moreover, I tested how this strategy would have performed in past market conditions back-test and under extremely bearish market conditions stress-test. The Correlation Risk Premium: Term Structure and Hedging http: As the recent financial crisis has shown, diversification benefits can suddenly evaporate when correlations unexpectedly increase. An analysis of unconditional and conditional correlation hedging strategies shows that only some conditional correlation hedging strategies add value.
Dispersion Trading dispersion trade option South Africa: An Analysis of Profitability and a Strategy Comparison http: A dispersion trade option trade is entered into when a trader believes that the constituents of an index will be more volatile than the index itself. The South African derivatives market is fairly advanced, however it still experiences inefficiencies and dispersion trades have been known to perform well in inefficient markets.
This paper tests the South African market for dispersion opportunities and explores various methods of executing these trades. The South African market shows positive results for dispersion trading; namely short-term reverse dispersion trading. CSV swaps performed poorly whereas call options experienced annual returns well above the market.
Volatility Dispersion Trading http: This papers studies an dispersion trade option trading strategy known as dispersion strategy to investigate the apparent risk premium for bearing correlation risk in the options dispersion trade option. Previous studies have attributed the profits to dispersion trading to the correlation risk premium embedded in index options.
The dispersion trade option alternative hypothesis argues that the profitability results from option market inefficiency. Institutional changes in the options market in late and provide a natural experiment to distinguish between these hypotheses. This provides evidence supporting the market inefficiency hypothesis and against the risk-based hypothesis since a fundamental market risk premium dispersion trade option not change as the market structure changes.
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