Dispersion trading: Exploring the profitability of dispersion trading strategies

Abstract

Once work done by Black-Scholes and other authors after them, placed option pricing and volatility within tractable reach of academicians as well as practitioners, it gave rise to an explosive growth in trading strategies and products based on various dimensions of volatility. Relationships between implied and realized volatility, volatility and the price of the underlying, volatility term structure were explored empirically and theoretically. Most recently a volatility index, VIX, was introduced which has been dubbed as the fear gauge of the market. As a result of these developments, financial institutions created and sold a number of products based on volatility to generate profits from these relationships. And it has been argued that it made their position what can be termed as essentially “short correlation”. Unless hedged, being short on correlation has the potential of wreaking havoc during market slides when correlations increase dramatically across all the stocks. To balance it, financial institutions sought out ways to be long correlation. Dispersion trading is one of the ways invented for that purpose. In the presented study, we have attempted to show whether a dispersion trading strategy is profitable in Indian context. We have estimated implied & realized volatilities and correlations of CNX Bank Index and its constituents over one year period, observed their patterns and developed naïve dispersion trading strategies based on the observed patterns. Finally, we have calculated their payoffs to check their profitability.