Exotic Stock Trade Beloved by Hedge Funds on Wall Street’s Radar

An under-the-radar options trade beloved by hedge funds pouncing on stock dislocations is entering the mainstream.

(Bloomberg) — An under-the-radar options trade beloved by hedge funds pouncing on stock dislocations is entering the mainstream.

The Cboe S&P 500 Dispersion Index (ticker DSPX), created to capture the difference in prices of options between the equity gauge and its underlying constituents, made its debut Wednesday. Cboe Global Markets says it aims to list a futures product tied to the new offering by the second quarter of next year.

It comes after a cohort of nimble money managers defied 2022’s bruising equity selloff to score double-digit gains by taking advantage of quirks in the world of equity derivatives. This year is again shaping up to be a favorable one for so-called dispersion trading as the Cboe Volatility Index, a gauge of broad market swings, stays muted even as stocks from technology to energy move wildly under the surface. 

“The popularity of the strategy has increased significantly lately,” said Peng Cheng, a strategist at JPMorgan Chase & Co. “Anything that adds transparency to the market is welcome, although the devil is in the details.”

There are a number of funds specializing in dispersion trading, including the Fulcrum Equity Dispersion Fund and the Systematic Dispersion Fund. In simplest terms, the trade is a bet on how much benchmark gauges will swing around relative to the volatility of stocks that make up the indexes. In practice, it’s far more complicated with derivatives such as volatility swaps and over-the-counter instruments often employed. Versions of the investing style might buy options on a basket of companies in a bullish, bearish or neutral bet.

Pinpointing the exact size of the niche market is next to impossible as the trade — mostly deployed by volatility hedge funds and banks packaging it into systematic strategies — is often part of a broader portfolio bet.

To Jitesh Kumar, a derivatives strategist at Societe Generale, the move by Cboe makes sense. 

“There isn’t any widely recognized benchmark for dispersion right now, so I can see the motivation,” he said. “There are investors who are restricted to the listed world, and hence a listed dispersion product again would likely appeal to that group of investors.” 

The new launch marks another major effort by Cboe to boost product offerings in an increasingly competitive exchange place. Last year, it expanded option expiry for the S&P 500 to cover all five weekdays, a move that instantly fueled a trading spike as traders sought ways to navigate the market turmoil inflicted by the Federal Reserve’s aggressive inflation-fighting campaign.  

Cboe is confident that the offering will find demand on Wall Street as it offers a simple way to gauge how company-specific risks are stacking up versus the market. Its futures contracts can become an easy tool for wagering on volatility particularly during earnings season when stock moves are more pronounced. 

John Hiatt, vice president at Cboe Labs, a team focused on product development, compares the new index to the firm’s flagship product — the VIX. Right now, trading in VIX futures averages 200,000 contracts a day. DSPX futures, which are subject to regulatory approval, would be considered quite successful achieving half of that size in volume.

“We’ve only been heartened by the response that we’ve gotten as we’ve brought the index to people to get feedback on,” Hiatt said. “They started to realize that if the market is standardized appropriately, it could be bigger than it was.”

The dispersion index, which Cboe developed with S&P Dow Jones Indices, closed little changed at 26.88 on its first day.

Simon Lepine, who runs the Dispersion Opportunities fund for LFIS Capital, says he’d consider using DSPX futures as part of a calendar trade, in which one sells a short-dated contract and buys another longer term. The rationale for any such bet: That stock-market winners and losers will be pronounced over time.

“It could offer a good tactical way of getting exposure,” he said. “It will obviously depend on the bid offer we will get on the future.”

(Adds fresh context on index trading in 13th paragraph)

More stories like this are available on bloomberg.com

©2023 Bloomberg L.P.