Index and Stock Option Dispersion with Implied Correlation

Summary

This project describes a dispersion strategy using Bank Nifty options and options on its constituent bank stocks. It compares implied volatility across the index and its components, using implied correlation as a signal: high correlation points toward selling index options and buying component options, while low correlation suggests the reverse. Straddles or strangles form the option positions, and futures are adjusted to keep the portfolio close to delta neutral. The authors outline calculating implied volatility with Black-Scholes, estimating implied correlation, selecting monthly options, and tracking profit and loss from both options and futures.

The project reports using 15-minute data and describes holding positions from the start of the month to expiry, with futures adjusted when delta crosses stated thresholds. It gives no detailed performance results or risk statistics for the strategy. The authors attribute possible returns to mean reversion in correlation or relative option pricing, while noting research that dispersion profitability diminished after 2000. The approach depends on hedging and market conditions; its low directional risk does not eliminate losses or establish that the strategy will remain profitable.

Key ideas

• Dispersion trades relative implied volatility between an index and its constituent stocks.
• Implied correlation is used to choose whether to buy index volatility or component volatility.
• The example uses monthly Bank Nifty options and constituent bank stock options.
• Futures positions are adjusted to keep the combined options exposure near delta neutral.
• Correlation mean reversion and relative option mispricing are proposed sources of potential returns.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.