Dispersion

What is Dispersion Mean reversion strategies focus on any two highly correlated assets where you trade that correlation. In this scenario, we are doing index correlation specifically on the SP 500 index because we believe it to be the most expensive from a vol perspective compared to others. In short, we go long individual SP500 stock volatility, and short SPY volatility

Which Assets are Long? In this scenario we are utilizing vega as our chief hedging statistic. Because of that, the concept is to buy equity vol that is relatively cheaper than index vol. Ex. If stock x has a hvg showing a typical 30 day vol of 20, and the IV is a 15 while SPY hvg shows a 30 day of 10 and a iv of 9, then we would buy equity vol because its IV is a lower % of historical vol compared to SPY. We are betting on mean reversion of volatility. We would then hedge our vega exposure by shorting SPY vol until our vega exposure was hedged in the proper ratio.

How to Buy and Sell Vol? There are two ways to buy and sell volatility. The first is to buy/sell a call and put option. The second is to synthetically create the straddle.

Synthetic Straddle This is done by buying ATM calls and shorting half as much stock, and then rebalancing to be delta neutral at days end and is referred to as gamma scalping. On the flip side, selling vol would be shorting puts, and shorting half as much stock (or whatever amount makes it delta neutral if your not using ATM’s) and then rebalancing at the end of the day to make it delta neutral.

What we’ve Covered What is dispersion How to choose which positions to open How to buy/sell vol (gamma scalping)

Null Vol What is the lowest possible vol you think the stock will fall to? I feel confident that TWTR is not going to trade at a 10 vol. What about a 20, a 50, who knows. The null vol is the amount of volatility you don’t have to hedge. Ex. On TWTR, I would not hedge 10 vol, I would feel comfortable betting a lot of money it will be more volatile than that.

Null Vol So, when creating your vega hedge, you take the current option price, check what it would be if you inserted your null vol, then subtract the two and divide by the original price. Then you take that fraction and multiply it by your original vega, and that is the vega you are going to be hedging by selling SPY vol.

Correlation I mentioned in the beginning, that we were trading correlation. Therefore, the correlation between SPY and any given individual equity movement is important. When correlation is high we want to sell more index premium, and when correlation is low we want to sell less. This is measured through the JCJ which tracks the correlation of SPY to stocks in the SP 500. The general rule is that when correlation is at a 70 or higher, we want to be close to fully hedged, but when correlation is at a 40, we want to be more like 65-70% hedged on our vega. This is an estimation on how aggressive we are with our null vols. The correlation index is more a guideline than anything else.

Null Vol Example AIZ atm 22 vol option costs 3.76 AIZ atm 10 vol costs 1.74 3.76-1.74)/3.76=.54 AIZ atm 22 vol vega= .17*.54=.09 vega We now need to hedge .09 spy vega for every .17 AIZ vega If one SPY option has a vega of .47, then we would have a approximately 5:1 AIZ straddle to SPY straddle ratio. If correlation were at a 70, then we may want to increase our exposure to SPY a little bit, and if correlation were at a 20, we may want to decrease.