Options Dispersion Trading with Correlation Signals and Delta Hedging

Summary

This project describes dispersion trading as a relative value strategy that trades options on an index against options on its component stocks. It estimates implied volatility from nearby option strikes using Black–Scholes, combines component volatilities, and forms a “dirty correlation” measure from the index and basket volatility estimates. Thresholds on that measure determine whether the strategy buys index options and sells component options, or takes the opposite position; a central threshold triggers closing the positions. The example uses straddles and strangles and considers several out-of-the-money strikes.

The strategy aims to benefit when implied correlation moves back toward its average, but it is exposed to rising correlation during market stress. The project calls for frequent delta monitoring and futures hedges, then includes option costs, hedge activity, settlement, and closeout in its profit calculation. It does not provide a clear performance evaluation or establish that the strategy is profitable despite its concluding claim. Results would depend on option pricing inputs, execution costs, liquidity, hedge frequency, and the chosen thresholds.

Key ideas

• Dispersion trading takes relative positions in index options and options on the index components.
• The project estimates implied volatility from nearby strikes and uses a volatility ratio as a correlation proxy.
• Entry direction depends on threshold signals, with a middle threshold used to exit positions.
• Futures are used to offset aggregate option delta, which the project proposes adjusting regularly.
• The approach can lose when correlations rise, especially during market stress, and the text does not supply a performance evaluation.

Tags

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