Source: Wall Street News

Once favored by hedge funds and volatility investors, niche stock trading has now evolved into one of Wall Street's most popular options strategies.

This investment strategy is dispersion trading (Dispersion Trading): selling broad-based stock index options on the NASDAQ 100 index and buying options on individual components of that stock index (such as Nvidia or Tesla).

The core of this strategy is to profit from differences in volatility between indices and individual stocks. The ideal conditions for trading are: individual stock prices fluctuate greatly (the value of individual stock options is higher), but their overall rise and fall cancel each other out, keeping the index stable (the value of index options falls).

The volatility of individual stocks is higher than the volatility of the index, which means that using individual stock options to hedge against index options is less expensive, which just creates room for investors to arbitrage. According to data compiled by Société Générale, the average volatility of the S&P 500 index's constituent stocks has now reached the highest level of volatility compared to the overall index since at least 2011.

At least double within 3 years

Traditionally, this strategy has been dominated by bank trading departments and “fast money” players such as hedge funds, but it is favored by more and more investors in the post-pandemic era.

According to estimates by Guillaume Flamarion, head of Citigroup's American multi-asset group, assets using this strategy have at least doubled, or possibly tripled, in the past three years.

Also, according to fintech company PremiaLab's survey data of 18 banks, the number of quantitative investment strategies (QIS) for discrete transactions has jumped 75% to more than 50 since the end of 2021.

The reason why discrete trading continues to grow is because it is viewed as a more affordable form of portfolio insurance.

According to Xavier Folleas, head of QIS at BNP Paribas, individual stock options purchased through discrete transactions increase in value when stocks plummet, but even when the market is calm, it can earn some profit by selling index volatility.

Finally, Folleas concluded, “Discretization trading is really the best option.”

The growing influx of capital into discrete trading is only a microcosm of the growth in the US options market. In fact, the overall trading volume of the US options market has doubled since 2019.

It is worth mentioning that the growth in the size of the dispersion strategy coincided with a period of declining exponential volatility, indicating that the dispersion strategy itself may be one of the reasons for the decline in volatility.

The “panic index” of US stocks — the Chicago Board Options Exchange Volatility Index (an indicator that tracks the cost of S&P 500 options, known as VIX) hit a five-year low last Thursday, indicating weak demand for hedging.

Costs have reached a 13-year high, can we still use the dispersion strategy now?

However, the expansion in the scale of discrete transactions has also raised some concerns, such as eroding its core arbitrage space.

As investors are betting that this model will continue, the cost of entering this strategy has now reached its highest level in at least 13 years, raising the threshold for future earnings.

As Vincent Cassot, head of derivatives strategy at Société Générale, said: “It's kind of a victim of its own success. This kind of deal is quite difficult if it is to continue to be profitable.”

However, if the “Seven Sisters” era continues, this kind of deal is still theoretically profitable.

Unlike big-market blue-chip stocks such as General Electric or Procter & Gamble in the past, blue-chip stocks in the US now often bring investors a roller coaster experience. Companies such as Nvidia, Tesla, and Meta have all experienced single-day fluctuations of at least 10% in recent months, providing investors with discrete strategies the volatility they crave.

Furthermore, Bloomberg data shows that since these fluctuations are largely special, the correlation between the S&P 500 index constituent stocks has also fallen to its lowest level in at least 13 years, which also helps dispersive trading.

“Compared to two years ago, there are fewer opportunities to evaluate it,” said Citi's Flamarion. But people will keep it in their portfolios.”

Editor/jayden