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
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
Implied Correlation
We can use the implied volatilities of the index and its components to derive a measure of average correlation
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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MBBO Bid Ask Spread
-100
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
-100
MBBO
4/3/2005
The return of the daily delta-hedged dispersion strategy (VT: Payoff Vt: Cost of the straddle)
With OTM Index Strangles StdDev of Returns Avg Returns Sharp Ratio 2.8833 11.318% 3.5801
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
$ Million
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Naive
PCA
Without trading costs, PCA strategy is less effective than Nave strategy
10/3/2004
4/3/2005
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
500 450 400 350 300 250 200 150 100 50 0 Naive PCA 500 450 400 350 300 250 200 150 100 50 0 Naive PCA
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-50
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5/3/2005
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
Long correlation
Strategy Results
Cumulative Returns for Trading Strategy vs Naive Strategy
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-100
Strategy
Naive
The strategy makes some good calls, some bad ones. Total returns are about the same
10/3/2004
4/3/2005
Strategy Results
Cumulative Returns for Trading Strategy with PCA vs. Naive PCA
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-100
PCA Naive
10/3/2004
4/3/2005
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