← InstitutionalLesson 15 · 4:02
Dispersion and correlation trading
Summary
You can explain why an index is calmer than its members, using arrows whose angle is set by correlation. You can read the implied correlation from index and member prices, describe the dispersion trade, and say why it wins small in calm markets and loses big in a crash.
Key terms
- correlation
- How much two prices move together, from one (always the same way) to zero (one tells you nothing about the other).
- implied correlation
- How much an index's option price says its stocks will move together, read from index and member prices.
- dispersion trade
- Selling an index's volatility and buying its members' volatility, a bet that they move together less than priced.
- mixing picture
- Drawing each stock as an arrow of weight times volatility, with correlation setting the angle, so the index is the arrow from start to end.
Check yourself
Answer each question to see why the right answer is right.
1. Three made-up stocks price 30%, 35% and 25% volatility, and an equal-weight index of them prices only 22%. Why is the index calmer?
2. In the two-stock arrow picture (half XYZ, half ABC), what happens to the index volatility as correlation falls from one?
3. For the three-stock index, never moving together would give a little over 17% and always together 30%. The index options price 22%. What is the implied correlation?
4. In the calm example, each stock moves exactly as priced but they move apart more than assumed. The index leg makes $893 and the member legs break even. What were you paid for?
5. In a crash, correlation jumps near one and each member's volatility doubles. The members leg makes $14,520 and the index leg loses $28,782. What does the lesson say about sizing?
Finished the video and the quiz? .