Index Options Arbitrage Through Implied Correlation

Summary

This article explains why index volatility depends on both the volatility of constituent stocks and the correlation among them. When stocks move more independently, their individual volatility can rise without a comparable increase in index volatility; when they move together, index volatility tends to rise more. The document proposes inferring average implied correlation from market prices by comparing implied volatility in index options with implied volatilities in constituent stock options.

The trading idea is to take a view on whether correlation will rise or fall. If a trader expects correlation to increase, the article suggests buying index options and selling constituent options in proportions based on index weights; the reverse relative-volatility view follows if correlation is expected to decline. It emphasizes that implementation involves approximating the weighted basket, reconciling different lot sizes, tracking combined portfolio Greeks, and rolling option strikes as markets move. These operational demands motivate automation. The article gives no pricing formula, backtest, transaction-cost analysis, or risk controls, so it presents a conceptual framework rather than evidence that the trade is profitable.

Key ideas

• Index volatility depends on constituent volatility and the correlation among constituent stocks.
• Comparing implied volatility from index and stock options can be used to estimate average implied correlation.
• A view that correlation will rise leads to buying index options and selling weighted constituent options in the proposed approach.
• Basket approximation, differing lot sizes, changing Greeks, and strike rolls make implementation complex.
• The article provides no backtest or transaction-cost evidence for the strategy.

Tags

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