Dispersion Trading: Empirical Evidence from U.S. Options Markets

This paper develops empirical evidence on a relatively new form of trading, known as “dispersion trading,” that is practiced by some quantitatively sophisticated hedge funds and by some proprietary bank trading desks. The results shed light on the efficiency with which U.S. options markets price volatility. Using end-of-day implied volatilities extracted from equity option prices for the stocks that comprise the S&P 500, I calculate the implied volatility of the S&P 500 using a modification of the Markowitz variance equation. I then compare this Markowitz-implied volatility to the implied volatility of the S&P 500 extracted directly from index options on the S&P 500. I then examine these contemporaneous measures of implied volatility for exploitable discrepancies both without transaction costs and with transaction costs. The study covers the period October 31, 2005 through November 1, 2007. I find that, consistent with the claims of dispersion traders, index option implied volatility tends to exceed the Markowitz-implied volatility derivable from the implied volatilities of the index components. Thus, from a trader’s perspective, index option implied volatility tends to be more often “rich” and component volatilities tend to be more often “cheap.” Nevertheless, there are times when the opposite is true, suggesting that potential dispersion trades can run in either direction.