It’s time to talk about the Dispersion Trade.
This trade has attracted a large amount of capital over the last years.
But what is the Dispersion Trade?
The Dispersion Trade involves buying volatility on single stocks constituting the index, and selling index volatility against it.
The idea is to monetize diversification and low correlations.
As long as single stocks become more and more uncorrelated, their individual volatility might remain high (you buy that) but the index volatility will keep coming down (you sell that) as low correlation amongst single stocks means less volatility at an index level.
The amount of money chasing and monetizing the Dispersion Trade is very large.
Large hedge funds often have multiple pods embarked in some version of this strategy, and they have been consistently making money for over a year now.
Today, the cost to enter a Dispersion Trade is quite elevated.
This is because implied correlations are priced to be very low already.
Yet investors are happy to pay a high price to enter this trade, effectively assuming that single stock correlation will stay low or drop even further (e.g. we won’t see a rapid deleveraging event).
The chart below shows how during the recent turbulence due to AI-related disruptions to certain sectors, the Dispersion Trade actually kept making money and its Sharpe Ratio increased dramatically.
This is because despite paying a higher and higher price to enter the trade, realized correlations amongst SPX constituents has been virtually zero.
If certain group of stocks were hammered, others performed nicely.
But what happens if you have a deleveraging event / sharp sell-off?
Single stocks correlations converge to 1 (e.g. they all sell off together), and chaos ensues.
At that point, a potential unwind would be painful as owners of the Dispersion Trade would need to bid up index vol (e.g. VIX and similar products) relatively aggressively.
Do you think the Dispersion Trade is a big risk for markets?
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