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IV_Trader · Nov 26, 2005

Quote from dantes:

The whole point of a dispersion trade is to capture the difference in vols between the components and the index. If you go short the component volatility and long the index volatility you are hoping that your gamma on the index will make you more money then what you loose on the components. This happens when the realized correlation between the individual stocks are high. If the correlation between indivdual stocks are low (they move all around the place) then the index realized volatility will be low (because on average things have stood still) and you will not gain anything on your index gamma but loose big on your short components gammas.

However if you don't delta hedge each option position in the dispersion there is not really any point of talking about gamma effects. You have much bigger risks to worry about.

I am sure this is an interesting trade but it is not a dispersion as the term normally is used.

This month I bought every Dow stock (except of GM) , sold covered ITM calls(for each) and bought DIA puts , I took the same position only ones before , what do you think ?

dantes · Nov 26, 2005

Quote from IV_Trader:

This month I bought every Dow stock (except of GM) , sold covered ITM calls(for each) and bought DIA puts , I took the same position only ones before , what do you think ?

Its a delta play with a capped upside and crash protection on the downside. Should be great if we continue to rally.

IV_Trader · Nov 26, 2005

Quote from dantes:

Its a delta play with a capped upside and crash protection on the downside. Should be great if we continue to rally.

yep , but actually I will make money if market goes up or down as long as all (or most) components will go to the same direction (collect IV difference from basket's calls and Index puts). Can happens in non-reporting month.

mysticman · Nov 26, 2005

Quote from dantes:
I am sure this is an interesting trade but it is not a dispersion as the term normally is used.

It has been made clear from the beginning that there are two types of dispersion trading -- regular and reversed. The reverse dispersion is usually not recommended or advisable, but because index options are now cheap and Profitaker wanted to look at it, we have been discussing it.

If you go short the component volatility and long the index volatility you are hoping that your gamma on the index will make you more money then what you loose on the components. This happens when the realized correlation between the individual stocks are high. If the correlation between indivdual stocks are low (they move all around the place) then the index realized volatility will be low (because on average things have stood still) and you will not gain anything on your index gamma but loose big on your short components gammas.

There is a third scenario where the correlation between components and index is high yet that between components is normal or low. This leads to a usual distribution pattern whose mean is shifts with the movement of the index.

However if you don't delta hedge each option position in the dispersion there is not really any point of talking about gamma effects. You have much bigger risks to worry about.

Why would the component options not be hedged? It is not each component option position that gets hedged . . . -- it is the aggregate of all of them that is hedged.

mysticman · Nov 26, 2005

Quote from IV_Trader:

This month I bought every Dow stock (except of GM) , sold covered ITM calls(for each) and bought DIA puts , I took the same position only ones before , what do you think ?

Another reverse dispersion post. You need to clarify because I can't believe you spent all that money to buy the stocks. If you did, essentially you are short OTM component puts and long index puts, which I assume are also OTM. So then the question is whether or not you did this for a credit? (using the OTM puts in the calc) If you didn't you lose if the index does not go down.

Profitaker · Nov 27, 2005

Quote from dantes:

Yes I see that you are long the index option but this means that you have exposure to correlation between your basket of stocks and the index.

Correct, Iâm long correlation and short dispersion.

Quote from dantes:

I would think you were looking to only have exposure to the correlation between vols?

I too donât know what you mean here. The correlation between two stocks is essentially the correlation between the stocks volatility and it's direction.

Quote from dantes:

However if you don't delta hedge each option position in the dispersion there is not really any point of talking about gamma effects. You have much bigger risks to worry about.

In a dispersion (or reverse) the components are hedged against the index and where you have 100% index replication I canât see any additional risks. Why would you want to delta hedge each individual stock in addition to being hedged against the index ? Perhaps you could better explain by example, so consider that just two stocks make up an index;

..................Value.........IV.........Weighting.........Correlation
Stock 1..........50..........10%..........0.5....................1
Stock 2..........50..........10%..........0.5....................1

Basket variance = 10%

Index............100..........8%

In the above example I would trade a reverse dispersion by selling the components IV and buying the index IV and arb a 2% profit. How would you âdelta hedgeâ that ?

Quote from IV_Trader:

This month I bought every Dow stock (except of GM) , sold covered ITM calls(for each) and bought DIA puts , I took the same position only ones before , what do you think ?

Why not just short DOW stock Puts rather than long stock/short calls ? Are they weighted so as to replicate the index ? Can you give us some numbers ?

Profitaker · Nov 27, 2005

Quote from Profitaker:

Stock 1) IV 25%, index weighting 20% Correlation 0.90
Stock 2) IV 20%, index weighting 30% Correlation 1.10
Stock 3) IV 20%, index weighting 25% Correlation 1.25
Stock 4) IV 15%, index weighting 20% Correlation 0.72
Stock 5) IV 35%, index weighting 5% Correlation 1.10

In this theoretical index above, where all options are ATM, how would you calculate the fair value for the composite index ATM options ?

Any chance of a worked example if one you gets a chance ? TIA

To answer my own question, the basket vol is 9.903%.

Finally got my head around the main formula;
http://www.elitetrader.com/vb/attachment.php?s=&postid=905452

dantes · Nov 28, 2005

Quote from Profitaker:

In a dispersion (or reverse) the components are hedged against the index and where you have 100% index replication I canÃ¯Â¿Â½t see any additional risks. Why would you want to delta hedge each individual stock in addition to being hedged against the index ? Perhaps you could better explain by example, so consider that just two stocks make up an index;

..................Value.........IV.........Weighting.........Correlation
Stock 1..........50..........10%..........0.5....................1
Stock 2..........50..........10%..........0.5....................1

Basket variance = 10%

Index............100..........8%

In the above example I would trade a reverse dispersion by selling the components IV and buying the index IV and arb a 2% profit. How would you Ã¯Â¿Â½delta hedgeÃ¯Â¿Â½ that ?

? [/B]

I must admit that this caused me to think a bit. Maybe I am wrong but I say this is kind of like being short gamma, you need to hedge your delta but really the best you can hope to loose as little as possible on your hedges.

I agree that if realized correlation between the stocks really are 1 then you don't need to hedge, but what about a scenario where stock 1 goes up to 60 and stock 2 is unchanged. Assuming 3 months to expiry my back of the envelope calculations tell me that you then loose more then the credit you did the spread for. However if you do hedge your delta in both the stock and index on the way up you do make back some of you losses.

Anyways, I am probably missing something but that is my thinking.

(So much easier if you are long the dispersion - and thus short correlation).

mysticman · Nov 28, 2005

Quote from dantes:
I agree that if realized correlation between the stocks really are 1 then you don't need to hedge...

You agree with who? Nobody has said that. Think about this again. You ALWAYS hedge. Correlation merely refines the hedge which is first of all and primarily based on volatility. It doesn't matter whether it is regular dispersion or reversed dispersion -- it is always the stocks vs. the index. In regular dispersion the index is overpriced and the stocks are not. In reverse dispersion the index is underpriced and the stocks are overpriced.
Try not thinking of everything in terms of gamma. There are other greeks. Dispersion is a volatility play.

mysticman · Nov 28, 2005

This is an update of the post showing the historical relationship between index and component volatility. For the Dow, the weighted implied volatility of the component stocks (WtdCompIV) is now 19.3%. The actual IV of the index (DIA) is 9.9%. One month ago the WtdCompIV was 22.8%, while the index IV was 12.9%.
Recently I have started to look at the different weights which each component contributes to the WtdCompIV. Attached is a graph for the Dow stocks.

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