Dispersion Trading

Dispersion trading is a kind of an index arbitrage strategy involving the selling of options on an index and buying a basket of options on the component stocks. The main idea behind dispersion trading is that the index is less volatile compared to its components. It is a sort of correlation trading, as trades are usually profitable at a time when the individual stocks are not strongly correlated. If individual stocks returns are widely dispersed then there may be a little movement in the index, but a large movement in the individual assets is possible. This would result in a large payoff on the individual stock options but a small loss on the short index option. It is also necessary to note that there is no need to buy all the index constituents’ options. You can choose cheaper stocks in terms of volatility.

In this strategy, generally, you short a straddle/strangle/iron condor on the index and long positions of straddle/ strangle/iron condor on few of the components of the index. If maximum dispersion is realized, the strategy will make money on the long options taken on the individual stocks and will lose little on the short position taken on the index.