Phish Food
Don Fishback’s on fire this week looking into the the lack of VIX pop.
I didn’t want to take too much time, and go overboard on the analysis. Which means I took some liberties with respect to the mathematics in trying to make things relatively simple. But the result is pretty much in line with what quite a few of you expected.
A major reason why VIX is as low as it is with respect to individual stock option volatility is due in large part to the relatively low correlation in the market. One stock tanks while another stock skyrockets. Both stocks have huge volatility. But the index remains unchanged, so its volatility remains low.
I realize we are getting a bit of a self-confirming circle here (I’ll throw Bill in too in this). But all roads do seem to lead to correlation. Plus we’re all beating this to death. And I would argue that end of the day, we assign too much import to one indicator that clearly doesn’t fully capture precisely what it is designed to measure.
But here’s something with interesting implications on the Dispersion Trade, the one where you go long individual stock gamma and short index gamma.
…..correlation tends to lead the the volatility differential by about three months. That is, when you start to see correlation rise, a few weeks later you’re likely to see the gap between the implied volatility of individual stock options and the implied volatility of index options narrow.
Basically when you put the trade on, you are betting on correlation. Let’s say you go long options gamma in basket of stocks and short gamma in SPY and/or QQQQ. You are rooting for correlation to decline; your best case has every stock going nuts, but in different directions such that the SPY or QQQQ does not budge. I would have expected options moves to predict correlation, not the other way around.
Since most have neither the time, capital, or inclination to put on and manage the trade, consider this more an interesting allocation tool. In other words, if you see correlation rise, you should switch from individual stock options to index options. Which of course makes perfect sense, I’m just surprised the order it happens.