New related paper to #237 – Dispersion Trading

"A number of studies have tried to explain the relative expensiveness of index options and the different properties that index option and individual option prices display. The two hypotheses that are prevalent is that 1) index options bear a risk premium lacking from individual options, and 2) option market demand and supply drive the option prices from their Black-Sholes values. Institutional changes in the option market in late 1999 and 2000, including cross-listing of options, the launch of the International Securities Exchange, a Justice Department investigation and settlement, and a marked reduction in bid-offer spreads, provide a “natural experiment” that allows one to distinguish between these hypotheses. Specifically, these changes in the market environment reduced the costs of arbitraging any differential pricing of individual equity and index options via dispersion trading. If the profitability of dispersion trading is due to miss-pricing of index options relative to individual equity options, one would expect the profitability of dispersion trading to be much reduced after 2000. In contrast, if the dispersion trading is compensation for bearing correlation risk, the change in the option market structure should not affect the profitability of this strategy. In this study, we show that the primitive dispersion strategy, as well as several improved dispersion strategies that revise the primitive dispersion strategies by conditioning, delta-hedging, subsetting, using index out-of-the-money strangles, are much more profitable before 2000 and then become unprofitable. This provides evidence that risk-based stories cannot fully explain the differential pricing anomaly. Future work on how implied volatilities of index options and individual options behave after the structural change might help us understand the specific source for the loss of profitability of dispersion strategies."

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