Dispersion trading is returning to the markets amidst a timid response to market uncertainty from Cboe’s Volatility Index™ (INDEXCBOE: VIX).
The trading strategy is based on the underlying difference between the implied volatility of S&P 500 Index options and the “actual” volatility observed. In 2022, market conditions were ideal for dispersion trading. Speaking of 2022, Scott Phillips of Lavaca Capital says: “The lack of a meaningful increase in implied volatility this year, despite a large market sell-off, is quite unusual.”
Phillips highlights that the VIX index’s close of 28.71 on June 30, 2022, was nine points, or 23%, lower than the average close compared to historical declines dating back to 1993. This discrepancy occurred during a period of heightened swings in the price of U.S. large-cap stocks, an aggressive monetary tightening strategy from the Fed and geopolitical tensions in Eastern Europe. The VIX had many reasons to reflect meaningfully heightened volatility, but it did not.
Opportunities And Pitfalls Of Discrepancies In Implied And Realized Volatility
Market participants have pondered the causes of this discrepancy, but a topic perhaps more worthy of investigation is what to do about its existence. Some nimble money managers employing dispersion trading, for example, reaped double-digit returns in 2022, while the market tanked by roughly 20%.
These traders recognized that market conditions favored selling options contracts in indices while buying options contracts in individual stocks. The rationale for this behavior arises from the known fact that the difference between implied and realized volatility in index options is greater than in individual stock options.
The discrepancy also has an impact on traders who use options to hedge against their portfolios. Phillips summarizes the bottom line for these traders: “Because of the lack of an implied volatility in 2022 relative to what has occurred in similar historical market drawdowns, those using put options to hedge a downside move in the S&P500 likely did not get the response they were looking for from their options hedges.”
Cboe Extends VIX Options Availability To 24 Hours A Day, 5 Days A Week
While the discrepancy between implied and realized volatility has shrunk since mid-2022, there’s no telling when this discrepancy may arise in the future.
Discrepancies in the market, especially those that are statistically significant and relatively unknown, can grant traders unique edges over their competitors. Cboe aims to improve the accessibility to these moments and offers expanded global trading hours (GTH) for VIX options in order to meet this goal.
Global trading hours (GTH) regime began on April 25th, 2022, and incorporates a brief “curb trading session,” a time period following regular trading hours where market participants can adjust, unwind, or close trades. Under this regime, traders from across the globe can participate in options trading strategies and engage in the pursuit of alpha.
Find out how you can turn volatility into your advantage here.
This article was originally published on Benzinga here.
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