Profitability of a Dispersion Trading Strategy

Dispersion trading is an investment strategy that is used to capitalize on the discrepancies in volatilities between an index and its constituents. The strategy involves buying or selling the index options and simultaneously buying or selling the constituent stocks’ options. This results in a long/short volatility portfolio.

Reference [1] provided an empirical analysis of a dispersion trading strategy to verify its profitability. The return of the dispersion trading strategy was 23.51% per year compared to the 9.71% return of the S&P 100 index during the same period. The Sharpe ratio of the dispersion trading strategy was 2.47, and the portfolio PnL had a low correlation (0.0372) with the S&P 100 index.

This article has provided a review of the theoretical basis for dispersion trading and has clarified its interpretation as an arbitrage on the mispricing of index options with regard to the overestimation of the implied correlations among its constituents. The empirical analysis showed how a simple version of dispersion trading, implemented using at-the-money plain vanilla straddles on the S&P 100 and a representative subsample of constituents, has significantly over performed the stock market, showing almost no correlation to the chosen index.

This article, once again, proved the viability of the dispersion trading strategy. However, as noted by the authors, there exist two issues related to execution,

While the empirical results show a strong predominance of dispersion trading if compared to a simple buy-and-hold strategy, a limitation of this analysis is the assumption of the absence of transaction costs. If we ignore slippage (the difference between the expected price of a trade and the price at which it is executed), only a market maker could have replicated the performance of our back-testing. Another limitation of the present analysis is the rather simplified delta hedging technique based upon a simple daily rebalancing. An optimized hedge would have gained higher returns, therefore compensating, at least partially, transaction costs.

We agree with the authors and believe that a hedging strategy based on delta bands would reduce the transaction costs and make the execution more affordable.

References

[1] P. Ferrari, G. Poy, and  G. Abate, Dispersion trading: an empirical analysis on the S&P 100 options, Investment Management and Financial Innovations, Volume 16, Issue 1, 2019

Originally Published Here: Profitability of a Dispersion Trading Strategy