How Hedge Funds Profit from Dispersion Trading During a Tech Sector Crash

In the Midst of the Market Crash on Monday, the Unexpected Winner Was the Popular Option Strategy “Dispersion Trading,” Which Bets on Market Calm.

The strategy, which involves buying options on individual stocks and selling contracts on an index, had its best day since 2020 after concerns about artificial intelligence shook the market and led to sell-offs in some of the largest American companies. The reason behind this is that dispersion trading, which is favored by hedge funds and banks, is actually a bet that the index will remain calmer than individual stocks.

The sell-off in the tech sector was so strong yet contained that the correlation between the stocks remained low, and the volatility of the indices stayed under control. This created an ideal scenario for the success of the dispersion strategy.

Once considered an exotic strategy, dispersion trading has become more popular in recent years after large banks began offering it through easily accessible swaps. Variations of the strategy offered by JPMorgan Chase & Co., Citigroup Inc., and BNP Paribas SA posted their best results in nearly five years. The Cboe S&P 500 Dispersion Index also saw its strongest growth since 2022.

“What initially appeared to be a chaotic ‘exit from stocks’ turned into a market situation where the correlations between stocks are even lower than last week,” wrote Michael Purves, CEO of Tallbacken Capital Advisors. “This explains why the VIX reaction remains weak.”

On Monday, shares of Nvidia Corp. and Broadcom Inc. dropped 17%, while the S&P 500 lost only 1.5%, and the Cboe Volatility Index (VIX) rose by just three points. This is in sharp contrast to the sell-offs in December, triggered by the hawkish stance of the Federal Reserve, or the August collapse caused by the breakdown in the “carry trade” market. In these cases, dispersion trading incurred losses.

The strategy works by selling options on a broad market index like the S&P 500 while simultaneously buying similar derivatives on its components such as Apple Inc. or Nvidia. The main idea is to take advantage of higher demand for hedging at the index level, meaning that investors are willing to pay more for protection on the index than for trading protection at the individual stock level.

While dispersion trading is offered in various forms, its success on Monday could strengthen its reputation as a defensive strategy, which had recently come into question due to concerns about an overwhelming influx of capital. The implied correlation in the S&P 500 fell to its lowest levels since 2011, making entry points for trading less attractive. This may be due to the huge influx of funds into the strategy, facilitated by quantitative investment strategies (QIS), through which banks turn popular systematic strategies into tradable swaps.

The more optimistic interpretation is that the correlation in indices is structurally decreasing because the tech mega-companies are behaving radically differently from the remaining 493 companies in the S&P 500. “These companies are living their own lives, which can differ significantly from the rest of the market,” comments Xavier Foléas, Global Head of QIS at BNP Paribas. “Therefore, the correlation seems to stabilize at lower levels than in the past.”

The Monday sell-off also highlighted other successful quantitative strategies. A strategy that buys stable stocks and sells volatile ones saw its strongest increase since 2020, according to a Dow Jones index. Another strategy, which focuses on undervalued companies, achieved its largest gain in the last seven weeks.

In conclusion, while tech giants are facing turbulence, both quantitative and dispersion strategies are proving to be effective hedging mechanisms during periods of market instability.