Is It Time for the Dispersion Trade?

12/29/2009 12:01 am EST


Adam Warner

Author, Options Volatility Trading

Well, you don't need me to tell you that volatility is extremely low right now, at least relative to the last 16 months or so. But is it time for the “dispersion trade?” A dispersion trade is where you buy options gamma in individual names versus shorting it in index names. You win if your individual names move around enough and with relatively low correlation such that the index does not move quite as much. Of course, few traders outside a trading desk have either the time or capital to put on many trades in this fashion, so it's more a concept to watch than anything else. And the concept is more or less net owning options in individual stocks and net selling them in indices.

Take Mastercard (MA), for example. Below, we have 30-day implied volatility (in yellow) over the past six months. Sometimes, names making new highs (like MA lately) will see volatility start to perk up a bit. Not Mastercard (MA)—it's getting cheaper and cheaper. And tough to argue as you can see the realized volatility in the stock itself is falling off a cliff as evidenced by 30-day HV on the upper graph and ten-day HV in the lower one.

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Nothing here says you want to net own options in a vacuum.

I'm not a big proponent of bottom fishing options volatility, and this MA chart shows exactly why.  Even if you are right here, “right” now becomes the low in options volatility, you may still lose money if you become a net buyer. You won't be able to make up your daily decay in MA options until realized volatility catches up with implied volatility, and it's tough to time if/when that happens.

But what if we compare MA to the S&P 500 (SPY)? I have the same two charts for SPY below, and as you can see, it's pretty identical. Implied volatility is at the lows, but still considerably higher than realized volatility.

Click to Enlarge

So what does this say for “dispersion?”

Well, my anecdotal experience says that you tend to win if volatility picks up, even though ostensibly, it is a volatility neutral play. Remember, you're selling options in one spot and net buying presumably similar dollar amounts in a host of others. For several reasons, the pickup in volatility translates better to individual names.

Again though, it's impractical and too capital intensive to trade many names this way. So let's summarize it as a lesson for traders instead. Virtually every option in America is cheap relative to recent options pricing, but expensive relative to realized volatility. If you have a notion to buy options, I'd stick to individual names. If you prefer shorting, do in an index or index-based ETF.

By Adam Warner of

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