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Index dispersion

Selling index volatility and buying volatility on the index members, a bet that correlation between the components will fall.

Index volatility is lower than the average volatility of its members because the members do not move together. The gap is a function of correlation, and dispersion traders take a view on it: short the index straddle, long a basket of single-name straddles.

The trade wins when stocks move a lot individually but the index does not — an earnings season where winners and losers offset. It loses badly in a crash, when correlation goes to one, the index moves more than the components did separately, and the short index leg is the wrong side of everything.

Example: an index implies 18% volatility while its members average 31%. A dispersion book sells the index straddle and buys member straddles sized to be vega neutral. It bleeds in quiet trending markets and loses fast in a correlated selloff.

Related: relative-value-volatility, correlation, variance-risk-premium, embedded-option

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Payoff of a long straddle at expiryA V shape with its point at the strike and both arms rising through zero as the price moves away.Profit / loss per share08090110120Profit if the move is big enough, in either directionStrike 100Breakeven 92Breakeven 108Max loss 8 — both premiums, if it finishes at 100Underlying price at expiry
Long straddle: payoff at expiry. A 100 call and a 100 put bought together for 8 make a V. A quiet market that ends near 100 costs the whole 8; the position only turns positive once the price finishes below 92 or above 108, whichever way it goes.

Educational only, not advice. Spotted an error? Post in Site Feedback.