Conjecture

When bonds selloff, investors should expect a wave of equity dispersion and subdued index volatility.

What is a dispersion trade?

Dispersion is a relative value trade comprised of

  • A short position on the underlying index’s implied volatility. The lower the realized volatility the better
  • A long position on the index components (that are likely to have volatility spike). The higher the average realized voatility the better.

Why trade dispersion?

Strong demand by outright investors for index performance protection from puts because of

  • A relatively high implied volatiltiy on the index in relation to its components
  • A steeper skew on an index’s implied volatitly that that of single stocks

Strong demand for yield enhancement products resulting in depressed volatility from

  • The impacts of hedging these products
  • The call overwritting flows on these products pushing short term vol lower on single stocks

Dispersion trades capture both of these dislocations!

Why consider dispersion when bonds selloff?

  • Significant sector rotation, usually leads to larger winners and losers, opening opportunities for depressed volatility levels on the index, but causing single stock volatilities to increase materially
  • Correlation discrepancies between the equity sector to bonds (USD 10Y Swap vs 3M RV SPX Baskets)

How to choose the right dispersion?

Two ways to structure the dispersion

  • Vega Flat - the index vega notional is set equal to the total vega notional of the stocks
  • Theta Flat - the index vega notional is overweight and higher than the total vega notional on the stocks
    • e.g. index vol: 20% & stocks weighted vol: 30% » vega notional: 30/20= 1.5x the notional on the stocks

Two market dynamics

  • Bullish Market - Theta Flat outperforms due to the extra short index volatility
  • Bearish Market - Vega Flat is more resilient thanks being to net long volatitily

Stock Selection

Ranking the stocks in the index by a metric that helps predict good and bad volatility. e.g. Interest Expense / EBITDA to select the top ~3-5 and the bottom ~4-8

What risks do you bear with dispersion?

  • Market Risk - The potential loss of the entire premium invested and unbounded losses in the worst case scenario
  • Credit Risk - The trade creates a credit risk on the counterparty and the guarantor. The counterparty’s and the guarantor’s insolvency may notably result in the partial or toal loss of the invested amount
  • Liquidity Risk - Market dislocations may render the product illiquid and impossible to withdroaw from