Friday, February 8, 2008

Index Volatility and Component Correlation

While I was sleeping soundly this morning, Adam at Daily Options Report was already up and deconstructing the volatility of the S&P 500 index. Drawing upon some data compiled by Bespoke Investment Group that show increasing correlation across the S&P 500 sectors during the course of the past six months, Adam concludes that the current high levels of index volatility (VIX, VXN, RVX, VXO, VXD) are due in part to this recent increase in correlation among the components of the S&P 500.

In Correlation Station (no relation to Terrapin Station), Adam breaks it down as follows:

“You can boil index volatility down to two basic factors. One is the volatility of the component stocks, the other is the correlation between those very stocks. And they can very much offset each other. Imagine a world where half the stocks were moving violently and basically trending in one direction, and the other half was moving violently the other way. Index volatility would be very low as the moves would pretty much offset each other.

What we have now is the opposite. Stocks aren't that cosmically volatile, but they are all moving in relative unison. Ergo index volatility is theoretically *high* relative to individual stock volatility.”

There is not much I can do to improve upon that explanation.

While an understanding of the correlation phenomenon is important, I’m sure many are wondering if the current situation is tradeable. For what little it is worth, I am not going to be taking trades that should be winners if correlations start unwinding, but I encourage those who are interested in this subject (yet another type of mean reversion play) to check out Adam’s thinking about some possible trades along these lines.


Unknown said...

One of the things I'm interested in is options arbitrage, or pairs trading. An example of this might be when one buys options in a low-IV underlying (say, an index) and sells options in a higher-IV underlying or underlyings (say, the components of an index) in the proper proportion. Of course, it would have to be done in a manner to eliminate or greatly reduce delta risk.

I think though, that this example is a fantasy, at least for a retail trader (me and I presume you). It would take the resources of a large trading firm for the capital, ability to fill at fair prices simultaneously, trade management, etc. for such a scheme... and the return on investment may not be worthwhile, given the transaction costs (entering AND unwinding).

LTCM used hedging schemes involving correlated products, and this led to its ultimate undoing. They made fabulous profits at first, but when the correlations failed (and refused to converge in time -- perhaps the ultimate failure of mean-reversion, or maybe the markets just got smart), they were unable to unwind their positions without massive losses, and the fund collapsed.

Still, the availability of a variety of sector and broad-based index or ETF options is very nice for a beginning pairs trader like myself, though liquidity and correlation are still significant concerns.


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