Dispersion trades are back after losing big in 2020

Bets on single-stock versus index volatility are “incredibly attractive by historical standards”

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An equity derivatives trade that lost hundreds of millions of dollars during the Covid-19 selloff last March is suddenly popular again.

The prospect of rising inflation leading to further sector rotations has renewed interest in dispersion trades, where investors go long single-stock volatility and short index volatility.

Dispersion is “the most exciting trade in the market right now”, says Hervé Guyon, head of flow strategy and solutions for Europe at Societe Generale.

This is because implied dispersion of the S&P 500 – the difference between the implied volatility of index options and the underlying single names – has fallen recently, lowering the cost of entering the trade. At the same time, realised dispersion – the realised volatility of single-stock options minus that of index options – is the highest it has been since 2008.  

“I’ve been doing this for 23 years and in terms of the ratio of potential upside to potential downside, it’s the best I’ve seen,” says Jason Goldberg, senior portfolio manager at volatility trading firm Capstone Investment Advisors, referring to the trade in the S&P.

The potential return on the trade equates to the spread between implied and realised dispersion. This has been wide before, notably around the time of the tech bubble bursting in 2000, but the cost of entering the trade was also higher at that time.

“If you think just about the probability distribution of what could happen, the opportunity is incredibly attractive by historical standards,” Goldberg says.

Realised dispersion for the Euro Stoxx 50 is also at the highest level since 2008, with the spread in the ninety-fifth percentile over the past five years.

And while returns from dispersion trades vary depending on their construction, SG’s Guyon says one simple version of the trade is up around 15% since last November’s US election. 

 

 

The dispersion trade suffered badly during the Covid selloff in March, when the volatility of indexes and single stocks moved higher in concert.

In its simplest form, the trade benefits from the higher volatility of single stocks relative to an index. The volatilities of uncorrelated individual stocks offset each other in indexes, creating a gap that can be wider during periods of market rotation.   

During the Covid selloff, equities crashed in sync, causing heavy losses except in some more sophisticated formats.

Conditions have switched in the dispersion trade’s favour as markets respond to the pandemic recovery. Frothy equity valuations and uncertainty about inflation have raised the likelihood of big sector rotations, Guyon says. “When you have big days for the repricing of inflation expectations, you see banks rebounding sharply and bond proxies being sold off,” Guyon explains. Those moves boost single-stock volatility but net out at the index level.

Guyon gives the example of March 3, when cyclical stocks such as banks and carmakers rallied sharply on expectations of higher inflation. Defensive stocks like healthcare and utilities fell and the Euro Stoxx 50 index stayed flat.

The US Federal Reserve has indicated that it will tolerate higher inflation, suggesting more surprises on inflation are likely going forward. “That will trigger lots of moves at the single-stock level that should not feed through into the index because the moves are decorrelated,” Guyon says.

Benn Eifert, CIO at QVR Advisors, a volatility-focused investment manager, says there is a “strong tailwind” for the trade as economies emerge from lockdowns.

“After the initial high correlation selloff we have seen dramatic factor and sector volatility – the reopening trade versus the stay-at-home trade, tech versus cyclicals – and we’ve had dramatic single-name realised volatility,” Eifert says.

“That was accentuated by the WallStreetBets activity,” he says, pointing to heavy retail trading in stocks and options of companies such as Tesla and Apple that are important index components.

The cost of putting the trade on had been elevated since the pandemic crisis. But that cost dropped in recent weeks, falling at the end of April to roughly the long-term average.

Investors put that down to flows. As the economic outlook brightens, banks have started to reduce long volatility positions accumulated from structured products issuance, Goldberg says. Institutions that are nervous about overpricing in equity markets, meanwhile, have added to demand for hedging: often buying puts on the S&P 500, he says.

 

 

Betting on dispersion could still be a bumpy ride for investors, however. A series of recent events, ranging from the Vix spike in 2018 to the Covid-19 selloff and, more recently, the GameStop and Archegos episodes, have blunted enthusiasm among hedge funds for selling volatility, Goldberg says. The reduced trading in volatility markets means dispersion trades could see wild swings in mark-to-market profits.

Goldberg points out the implied volatility on a benchmark S&P ETF put option has rallied from 23% to 26% since the start of April, despite the S&P 500 rising 6% over the same period and realised volatility remaining steady at around 13% – conditions in which implied volatility might be expected to remain flat or fall.

“In the past the volatility of volatility strategies was quite low,” he says. “If something moved a tenth of a vol point, five people would pick up the phone and call the bank and say: ‘I want in’. It’s not like that anymore. The volatility of returns is much higher and it’s probably going to remain much higher for the foreseeable future.”

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