Toward a better understanding of dispersion trading

In this paper we are going back to the volatility dispersion trading. Basically this kind of strategy tries to exploit the relationship between the implied volatility of the index and the implied volatility of its components.
Some index options are only traded at a single exchange as compared with equity options which may be traded at up to five exchanges (mostly in US markets).
Those options have often high bid-ask spreads as compared to single stock options and have high implied volatility as compared with the historical volatility of the index.
One way to take advantages from that is to sell index options (close to ATM, straddles or strangles) et to buy component options. We do not engage the reverse position because index options are expensive et because we can be surprised with a single stock (e.g. bankruptcy) but not with the entire index. Each option is delta hedged with its own underlying, so it is really a volatility play and more precisely a correlation play.

Ordinarily, when markets fall volatility rises and correlation is high (every stock price takes the same direction). If we sell straddles in high volatility environments we should be worried : « Can volatility increase even more ? ». Volatility dispersion trades are a way to reduce the risk since correlations are bounded. Hence we would like sell high correlation (close to 1) by selling the index volatility, protect our volatility position by buying components options and take profit of a correlation decrease.

Understanding_dispersion_trading

NB : password = dispersion