Dispersion Trading on the Dow Jones Industrial Average

Outline
I- Dispersion strategy is based on implied vs realized correlation II- A study of a nave strategy on the DJI from 2000 to 2005 III- Two other improvements

IV- An improvement of the nave strategy: Component selection

V- Implementing a timing strategy

I What is dispersion trading ?

What is Dispersion Trading?

Dispersion trading involves trading the volatility of an index against that of the indexs components It involves making a bet on whether the components will move together as a unit or disperse and move separately

We can replicate the index IV with its components IV

Use each component IV:

Correlation Weighted Component Vol matches actual DJX Implied Vols

Implied Correlation
We can use the implied volatilities of the index and its components to derive a measure of average correlation

More Implied Correlations

As expected, the implied correlation is less volatile when longer lookback periods are used

Correlation on the DOW seems overestimated

We observe that the realized correlation of the index is less than its implied correlation. The index straddles might therefore seem overpriced

How can we earn profits from this observation ?

II A nave strategy on the DOW

Nave Strategy
Each month, sell index volatility, buy component volatility: Short Correlation Executed using ATM front month straddles

Professionals sometimes use variance swaps instead Take a gross exposure of $100 at the beginning of each month Studied using (1) the MBBO price and (2) the bid-ask spread

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Naive Strategy Cumulative Returns, MBBO

A Nave dispersion strategy seems profitable

What happens when we take Bid/Ask into account ?

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MBBO Bid Ask Spread

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Bid/Ask spread lowers profit

Naive Strategy Cumulative Return

Profitability is reduced after the volatility surge following 9/11

It is possible that, after the stock market crash following 9/11, the market players learned to better price index volatility and to better forecast the correlation amongst component stocks.
Naive Strategy Cumulative Return

Before and After the Volatility Spike of 9/11 1/2000-10/11 StdDev of Returns 1.1680275 Avg Returns 23.884% Sharp Ratio 4.0895931 10/11-6/2005 1.145478 4.762% 1.774507

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Bid Ask Spread

MBBO

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III Two possible strategy improvements

Refinement: Delta-Neutral Strategy

We tested the enhancement of following a delta-neutral strategy The dispersion position's delta exposure to stock i

The return of the daily delta-hedged dispersion strategy (VT: Payoff Vt: Cost of the straddle)

Refinement: Delta-Neutral Strategy

Delta Hedge the delta positions of straddles daily (assuming no Transaction Costs) With delta hedging, the average monthly return decreases while the Sharpe ratio goes up slightly.

Performance Comparison Against Base Case

With Delta Hedging Without Delta Hedging 1.7878 10.940% 3.780734

No Transc. Costs StdDev of Returns Avg Returns Sharp Ratio

2.2415 7.918% 3.921145

Refinement: OTM Index Strangles

Buy cheapest individual options and write most expensive index options. i.e. Buy ATM individual straddles and sell OTM index strangles Selling pricey strangles increases the average monthly return slightly, while the Sharpe ratio goes down a bit.
Performance Comparison Against Base Case

With OTM Index Strangles StdDev of Returns Avg Returns Sharp Ratio 2.8833 11.318% 3.5801

With ATM Straddles 1.7878 10.940% 3.7807

IV- Selecting a subset of the components with PCA

30 components in the Dow Jones: High trading costs

How do we reduce the number of components in the strategy?

PCA can determine the components that explain most of the index variance
Principal Components Analysis is a 3 step method (Su, 2005):
Step 1 : Write the weighted covariance matrix over the previous 1 year data

Step 2: Find the Principal Components: Eigenvectors of the diagonalized matrix Step 3: Run a multiple correlation to find how many original components to keep at each trading date

Each month we choose a subset of 10-13 stocks of the DOW that best explains 80% of the variance

On average 10 DJI components explain more than 80% of the variance

PCA vs Naive - MBBO prices
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$ Million

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PCA

Without trading costs, PCA strategy is less effective than Nave strategy

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With trading costs, PCA selection has better results than Naive
The higher the transaction cost, the better the relative performance of the PCA selection strategy:
PCA vs Naive - $0.15/contract
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PCA vs Naive - $0.45/contract

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Still, profits stop increasing after 2002: A timing strategy is needed

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V- Implementing a conditioning strategy

The Timing of the Dispersion Trade

Potential indicators : Realized Values: Calculated on the basis of historical market data, e.g. values of historical volatility, observed correlations between stock prices . Implied Values: Values implied by the option prices observed on the current day in the market. Theoretical Values: Calculated on the basis of portfolio theory.

Conditioning Strategy

Goal: Find a signal to go long/short correlation that provides better results than the nave strategy.

Idea: Compare 30 day implied correlation to its 3 month moving average. Short correlation when significantly above 3 month MA: We expect correlation to go down Long correlation when significantly below We expect correlation to go up
30 Day Implied Correl. vs. 3 Month Moving Average

Strategy Details
Initiate short correlation Position (short index vol, long component vol) when correlation/MA > 1.4 Initiate long correlation position when correlation/MA < 0.8

Short correlation

Always have a position on

Long correlation

The ratio of implied correlation to its 3 month MA seems to mean revert

Strategy Results
Cumulative Returns for Trading Strategy vs Naive Strategy
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Strategy

Naive

The strategy makes some good calls, some bad ones. Total returns are about the same

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Strategy Results
Cumulative Returns for Trading Strategy with PCA vs. Naive PCA
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PCA Trading Strategy

PCA Naive

Success! Using PCA, the strategy outperforms the Nave PCA

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Conclusions
Dispersion trading on the DOW seemed a very easy and profitable strategy until 9/11 After 9/11, a clever conditional strategy is needed to keep making profits Delta Hedging reduces the variance and increases the Sharpe ratio Selling index strangles rather than straddles increases returns but reduces the Sharpe ratio We can use PCA to replicate the returns with lower trading costs Our timing idea produced mediocre results, but when combined with PCA, was surprisingly effective