Profitability of Dispersion Trading in a Less Liquid Market

Dispersion trading is an options trading strategy that capitalizes on the spread or difference in implied volatility between index options and individual stock options. The basic premise involves selling index options while simultaneously buying options on individual components of the index. Traders expect that the implied volatility of individual stocks will either increase or decrease less than that of the overall index.

Reference [1] investigated the profitability of dispersion trading in the Swedish market. The authors pointed out,

The simulation proved that the vega risk could be well hedged using the proposed strategy. Under the condition that no transaction costs are paid during the simulation, the hedging method would also result in positive results. Although the returns from the strategy are notably high, taking into account the substantial transaction costs renders the strategy unprofitable during the simulated period. The large transaction costs are the result of the weights in the tracking portfolio being re-calculated on a daily basis. A less frequent re-balancing of the weights in the tracking portfolio would result in lower transaction costs but would likely result in a worse hedge and lower correlation to the index. The profitability when trading at mid spread is a consequence of expensive index volatility being hedged with cheap single-stock volatility.

In short, the study concluded that if we use the mid-price, then dispersion trading is profitable. However, when considering transaction costs and the B/A spreads, the strategy becomes less profitable.

We agree with the author that the strategy can be improved by hedging less frequently. However, this will lead to an increase in PnL variance. But we note that this does not necessarily result in a smaller expected return.

Let us know what you think in the comments below or in the discussion forum.

References

[1]  Albin Irell Fridlund and Johanna Heberlei, Dispersion Trading: A Way to Hedge Vega Risk in Index Options,  2023, KTH Royal Institute of Technology

Originally Published Here: Profitability of Dispersion Trading in a Less Liquid Market

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