The market has been behaving strangely recently, with stocks moving in virtual lockstep with one another.
But that isn’t likely to last forever, and some investors are setting up trades designed to benefit when the market returns to normal.
‘Correlation’ is the term investors use to describe the degree to which stocks trade in tandem. A reading of 100% means every stock moved with the index. There are two kinds: actual correlation based on historical data, and ‘implied correlation,’ based on options traders’ expectations of correlation in the future.
Right now, the options market puts implied correlation at more than 80%, meaning that eight out of 10 stocks in the Standard & Poor’s 500-stock index will move in the same direction as the index.
Typically, when stock-market volatility falls, as it has in the past few months, so does the overall market’s implied correlation. Not this time.
The Chicago Board Options Exchange Volatility Index, or VIX, has fallen by almost half during the past three months. Yet the market’s implied correlation has barely budged, falling from a high of 78% in May to 73% now, still well above its level of 56% in April, according to CBOE data.
In fact, the implied correlation for the S&P 500 is higher now than it was even during the peak of the financial crisis in early 2009.
Some of today’s higher correlations could be permanent, a result of the huge shift in recent years toward ETFs and away from individual stocks.
Still, some pros are betting that correlations will fall.
‘I’m surprised correlation has stayed this high,’ says Rajesh Malhotra, head of index trading, Americas, at Nomura Securities International. ‘At some point it should move back toward 50%.’
One way the pros try to take advantage of high implied correlation is by using an arbitrage strategy called a dispersion trade: They buy options on an individual stock and sell options on an ETF. The bet is that the two will become less correlated over time.
A slightly easier way for ordinary investors to play the dispersion theme is by using a variation of a ‘covered call’ strategy. Normally a covered call involves buying a stock and then selling a call option on that stock, giving the buyer the right to buy the stock if it hits a certain price.
By selling the call they get to collect a premium upfront, which helps protect against losses on the stock they bought. A covered call is a way to get some upside while protecting some on the downside.
Betting on Dispersion
To bet on dispersion, you can tweak the covered-call strategy slightly: You buy an individual stock and simultaneously sell a call on an ETF. Why? Because during periods of high implied correlation the premium on the ETF is typically higher than it would be for the individual stock, making the trade potentially more profitable.
‘When implied correlation is high, you get extra risk premium to sell the ETF-index option,’ says says John Martin, a managing director for equity derivatives at Ticonderoga Securities, a New York institutional broker dealer.
Consider options on the Market Vectors Gold Miners ETF, or GDX, which tracks the stocks of gold producers. As of July 27, GDX options were trading with an average volatility of 34%, while options on two of its largest components, Barrick Gold Corp. and Newmont Mining Corp., priced in implied volatility of 33.4% and 31.5%, according to Ticonderoga.
Investors who buy, say, Newmont Mining at $55.75 could sell January $62.50 calls at $2.40 and lock in a maximum gain of 16.5%. But they could sell the equivalent 54 in GDX instead and pick up 17%. In the world of fast-fingered trading, that is a big gap to exploit.
There is a category of hedge funds called ‘volatility’ funds that typically make correlation and dispersion bets. Some dispersion traders took a hit in May and June when implied correlation surged to 80%. But they could be in good position to capitalize on falling correlation in the future.
‘It is a good time to be doing dispersion because of the unique conditions in the market,’ says says Ben Borton, a principal at hedge fund MM Capital in New York. ‘The worst case is that the world will be very correlated, and that is largely what is priced in, so the downside is limited from these levels.’
Mutual-fund investors, meanwhile, can glean a simple rule of thumb from implied correlation: When the CBOE’s Implied Correlation Index moves from low to high, indexes are a better bet than active fund managers, because more stocks will be moving in unison. Conversely, when the Implied Correlation Index moves from high to low, active managers are the way to go.
‘Implied correlation is an indication of whether people are trading individual stocks or the stock market,’ says David Silber, head of equity derivatives at Jefferies. At some point, ‘you’ll see people move back into single stocks.’