Volatility Dispersion?

BAC v XLF

BAC v XLF

WFC v XLF

WFC v XLF

These are charts of Daily Implied Volatility versus the IV of a benchmark. Typically trading vol versus benchmark vol is called ‘Dispersion’ Trading; a nice fancy name to show others how smart you are. The basic idea is to compare an index volatility versus a constituents’ vol. Since the index is made of the components there should be some relationship between the two. The profitability will be based on your view of current and future correlation between those constituents and its index so additionally the dispersion trade can be considered correlation trading. I’m not on the sell side so things may have changed but in the past these desks were nice profit centers at banks however these days it’s more likely to be utilized in a liquidity providing capacity, one can take down big paper in a single name and hedge/balance the book by creating a dispersion book. This requires low spreads & commissions along wit capital usually only available to the large desks.

My idea here was to continue with the systematic/discretionary theme and analyze individual names versus benchmarks. If BAC vol is rich relative to XLF is there some reversion; pairs trading of volatility. These were two samples I picked and one can see a nice MR process here. Unfortunately one needs to analyze commissions and slippage involved in entering/existing a position. Additionally the cost and infrastructure needed to delta hedge exposure. Volatility discrepancies in index components can also be due to earnings and news driven events which need to be considered in any short gamma position. But perhaps a systematic scan of dispersion can result in a handful of additional trade ideas…..

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~ by largecaptrader on June 23, 2009.

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