Dispersion Trading
Imagine you’re a trader, sitting at your desk, staring at your computer screen, waiting for the perfect opportunity to strike. You’ve been watching the market closely, analyzing every tick, every trend, every pattern. Suddenly, you notice something unusual. The stock prices of two companies in the same industry are moving in opposite directions.
This is a classic example of dispersion trading, a strategy that can lead to significant profits if executed correctly.
Dispersion trading is a technique that involves exploiting the differences in price movements between related securities, such as stocks in the same industry or sector. It’s , like every other strategy out there, a high-risk, high-reward strategy that requires a strict trading rules and backtesting to succeed to capitalize on these discrepancies.
What is Dispersion Trading?
Dispersion trading is regarded as a sophisticated strategy employed by traders to capitalize on the variance in price movements among a set of related assets, typically options or stocks. The core idea behind dispersion trading is to profit from the relative price movements of these assets within a portfolio. It’s a kind of market neutral trading strategy.
When executed effectively, it allows traders to create a diversified position that can thrive in various market conditions, making it an invaluable tool for both novice and seasoned traders.
Pros and cons of Options Dispersion Trading
Dispersion trading is a popular options trading strategy that involves taking positions on the spread between the implied volatility of individual stocks and the actual market volatility. Here are some pros and cons of dispersion trading:
Pros:
- Profit Potential: Dispersion trading can offer significant profit potential when executed correctly. Traders can profit from discrepancies between the implied and realized volatilities of different stocks.
- Diversification: This strategy allows traders to diversify their positions by trading a basket of individual stocks, which can help reduce risk compared to trading a single stock.
- Market Neutral: Dispersion trading is often market-neutral, meaning it is less sensitive to overall market movements. This can be advantageous in turbulent or uncertain market conditions.
- Scalability: It can be scaled up or down easily by adding or removing positions in different stocks, making it suitable for traders with different risk appetites and capital levels.
- Hedging Opportunities: Dispersion trading can also be used for hedging purposes. If a trader holds a portfolio of stocks, they can use dispersion trading to hedge against market volatility.
Cons:
- Complexity: Dispersion trading is a complex strategy that requires a deep understanding of options, implied volatility, and correlation dynamics among the stocks being traded. Novice traders may find it challenging to implement effectively.
- Transaction Costs: Frequent trading and adjustments can lead to significant transaction costs, including commissions and bid-ask spreads. These costs can eat into profits, especially for small-scale traders. Options have higher slippage than stocks (normally).
- Risk Management: Managing risk in dispersion trading can be challenging, as it involves multiple positions in different options contracts.
- Capital Requirements: Depending on the size of the portfolio and the number of options positions, dispersion trading may require a significant amount of capital to implement effectively.
- Limited Profit Potential: While dispersion trading offers profit potential, the potential gains may be limited compared to other options strategies that involve taking more directional positions. The max gains are capped, just like losses are capped.
- Monitoring and Adjustments: Traders need to constantly monitor their positions and be prepared to make adjustments as market conditions change. This can be time-consuming and stressful.
- Correlation Risk: One of the key risks in dispersion trading is correlation risk. If the correlation between the stocks in the portfolio changes unexpectedly, it can lead to losses. We have covered correlation risk in trading in a separate article.
What are the risks of Dispersion Trading?
While it can be profitable, like any trading strategy, it comes with its own set of risks. Here are some of the risks associated with dispersion trading:
- Volatility Risk: Dispersion trading relies on the relative movement of underlying assets within an index or basket. If the overall market volatility increases significantly, it can lead to larger price swings in individual assets, making it more challenging to predict their relative movements accurately.
- Correlation Risk: The strategy assumes that the correlations between the underlying assets will change in a predictable way. However, correlation levels can be unpredictable and can change rapidly due to various factors such as economic events, geopolitical events, or market sentiment. Correlations change all the way, but they tend to increase when markets are turbulent.
- Gamma Risk: Dispersion trading often involves options positions, which have nonlinear payoffs. The gamma risk refers to the sensitivity of an option’s delta (the rate of change of the option price concerning the underlying asset’s price) to changes in the underlying asset’s price. Rapid price movements can result in significant changes in delta, leading to potential losses if not managed properly.
- Liquidity Risk: Some dispersion trading strategies may involve less liquid options or derivatives contracts. Illiquid markets can lead to difficulties in executing trades at desired prices, especially when entering or exiting positions.
- Margin and Leverage Risk: Using options and derivatives can involve leverage, which amplifies both potential profits and losses. High leverage can lead to margin calls and significant losses if the trade goes against the trader.
- Model Risk: Dispersion trading relies heavily on mathematical models and assumptions about the behavior of underlying assets and options. If these models are incorrect or if the assumptions do not hold in practice, the strategy can result in losses.
- Event Risk: Unexpected events, such as earnings reports, mergers, or other corporate announcements, can cause significant price movements in individual assets, which can disrupt the dispersion trading strategy.
- Market Risk: Like any trading strategy, dispersion trading is exposed to general market risk, such as overall market downturns or crashes that can affect all assets within the index or basket.
- Counterparty Risk: When trading options or other derivatives, there is a counterparty involved in the trade. If the counterparty defaults or encounters financial difficulties, it can lead to losses for the trader.
- Regulatory Risk: Changes in regulations governing derivatives markets or options trading can impact the profitability and feasibility of dispersion trading strategies.
It’s essential to thoroughly understand the risks involved and have a well-defined trading plan when engaging in dispersion trading or any trading strategy.
How Quantified Strategies Can Help
Quantified Strategies is a company that specializes in providing data-driven insights and strategies to traders.
We can help traders identify trading opportunities and strategies. You might want to have a look at our different memberships.
The Statistical Edge and Dispersion Trading – Evidence And Statistics
A study by Dr. Andrew Lo, a renowned professor of finance at MIT, found that dispersion trading strategies have generated consistently positive returns over long periods.
His research suggests that this strategy can provide protection during periods of high market volatility, while still offering the potential for attractive returns during calmer market conditions.
Furthermore, a study by Goldman Sachs analyzed the performance of dispersion trading strategies across various markets and found that they consistently beat the market benchmarks. These findings reinforce the potential of dispersion trading as a viable investment approach.
A study by Qian Deng from 2008 called Volatility Dispersion Trading suggests that dispersion trading is a lot less profitable now than before. We quote from his paper:
“In this study, we show that the primitive dispersion strategy, as well as several improved dispersion strategies that revise the primitive dispersion strategies by conditioning,delta-hedging, subsetting, using index out-of-the-money strangles, are much more profitable before 2000 and then become unprofitable.”
Conclusion
Dispersion trading is a powerful strategy that can lead to significant profits for traders. However, it’s not without its risks, just like any other type of trading strategy. To succeed in dispersion trading, traders need to have a deep understanding of the market and the ability to identify and capitalize on discrepancies. Dispersion trading is complicated, and not for the average retail trader.
