Popular Hedge Fund Option Trade Adjusts With Turbulent Market

(Bloomberg) — For hedge funds, last year’s popular index dispersion trade has increasingly morphed into more focused strategies. 

With tariff tantrums upending global markets, macroeconomic concerns have taken over, overshadowing individual corporate news. In April, the implied correlation on the S&P 500 Index averaged its highest level in more than two years, remaining elevated even at the height of the earnings season. The trend was similar in Europe.

While that would typically hurt returns from so-called dispersion strategies that bet on differences in volatility between an index and its members, it didn’t this time. Sophisticated investors have shifted away from the broad gauges to smaller, hand-picked baskets, allowing them to profit from the trade. 

“Despite the recent spike in correlation, dispersion trades have been profitable over the last few months, as baskets appear to have been concentrated on names that saw higher realized volatility,” said Michalis Onisiforou, a flow derivatives strategist at Banco Bilbao Vizcaya Argentaria SA. In Europe, vol-arb traders have been locking in profits in the past couple of weeks by unwinding the names with the highest realized volatility as implied fell, he added. 

A hypothetical basket looking at the volatility of select Swiss financial firms versus the Swiss Market Index shows that the realized spread widened in April, based on data compiled by Bloomberg. That would lead to profits to anyone doing the trade.

While the three-month S&P 500 implied correlation has fallen from a high earlier in April, its average for the month was about double the one-year mean. Quantitative Investment Strategies — of which some look to profit from dispersion — that have proliferated across equity markets recently were broadly active, and dispersion variants in particular did “very well,” according to Adrien Geliot, the chief executive officer of Premialab, a firm tracking QIS offerings.  

Defensive dispersion setups were popular even before April 2, but they’ve become more relevant in the current volatility environment. To actively manage them, JPMorgan Chase & Co. strategists have recommended techniques that take care of correlation shocks, including setting up partial intraday hedges on the short volatility index leg of the trade or overlaying a long volatility position via VIX or VStoxx Index option structures.

Bank of America Corp. strategists pointed out that the tariff threat to the global economy is man-made and reversible, and therefore left-tail risks are unlikely absent an exogenous shock. They recommended last week a more aggressive dispersion setup with a short volatility bias.

The abundance of volatility selling strategies also appears to have escaped the tariff turmoil with little damage so far. Some tactical multi-strat funds capitalized on the elevated volatility levels in early April by entering the carry — or short-volatility — trade. Some funds that were able to time the entry point well ended up making double-digit returns in just a few days as volatility collapsed, according to Geliot.

Yet the recent slump in volatility is a sign that the environment is changing, and the implementation of the carry trade has become much more focused on fixed-strike options, according to Antoine Porcheret, head of institutional structuring for the UK, Europe, Middle East and Africa at Citigroup Inc. As a result, equity volatility in the market is much more tamed. 

“Shorting vol is increasingly being done in a risk-limited way,” he said. Dealers are less exposed to volatility changes, so “in draw-downs it is possible to observe less vol reactivity like you did pre-Covid, or any spike being short-lived,” he added.

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