Dispersion trading: Empirical evidence from U.S. options markets
AbstractThis paper develops empirical evidence on the viability of a form of volatility trading known as "dispersion trading." 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, the implied volatility of the S&P 500 is computed using a modification of the Markowitz variance equation. This Markowitz-implied volatility is then compared to the implied volatility of the S&P 500 extracted directly from index options on the S&P 500. These contemporaneous measures of implied volatility are then examined for exploitable discrepancies both with and without transaction costs. The study covers the period October 31, 2005 through November 1, 2007. It is shown that, from a trader's perspective, index option implied volatility tended to be more often "rich" and component volatilities tended to be more often "cheap." Nevertheless, there were times when the opposite was true; suggesting that potential dispersion trades can run in either direction.
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Bibliographic InfoArticle provided by Elsevier in its journal Global Finance Journal.
Volume (Year): 20 (2009)
Issue (Month): 3 ()
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Web page: http://www.elsevier.com/locate/inca/620162
Dispersion trading Implied volatility Volatility trading Correlation trading Equity options;
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Christensen, B. J. & Prabhala, N. R., 1998. "The relation between implied and realized volatility," Journal of Financial Economics, Elsevier, vol. 50(2), pages 125-150, November.
- Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
- Joshua D. Coval, 2001. "Expected Option Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 983-1009, 06.
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