A growing number of hedge funds are positioning for a reversal in one of the market’s most profitable options strategies, betting that unusually large swings in individual stocks will eventually give way to higher volatility at the index level, according to a report by Bloomberg.
Traditional dispersion trades – which profit when individual stocks are more volatile than the broader market – have delivered strong returns in recent years. However, with measures of stock-level dispersion reaching their highest levels since 2020 and implied correlation among the largest US equities close to record lows, some managers are beginning to take the opposite view.
The so-called reverse dispersion trade seeks to benefit if stocks begin moving more in tandem and volatility returns to broad market indices such as the S&P 500.
Among those adopting the strategy is Adapt Investment Managers. Chief investment officer Alexis Maubourguet said reverse dispersion remains one of the firm’s highest-conviction positions, arguing that the conventional dispersion trade has become increasingly crowded.
Although the position detracted from performance during the previous quarter as stock correlations continued to decline, Maubourguet believes current market conditions offer an attractive asymmetric opportunity should a macroeconomic shock cause stocks to move together again.
Data from Cboe Global Markets shows one-month implied dispersion among large-cap US equities is at its highest level since 2020, while three-month implied correlation recently fell to around 7%, close to the lowest reading on record.
Several market participants believe those levels leave room for a rebound. David Elms, head of diversified alternatives at Janus Henderson, noted that average implied correlation over the past decade has been approximately 33%, climbing above 80% during the Covid-19 market turmoil. A return towards historical norms, he said, would favour reverse dispersion strategies.
Market participants also report increasing interest in taking the opposite side of the traditional trade. Mandy Xu, head of derivatives market intelligence at Cboe, said some investors are becoming reluctant to initiate new dispersion positions at current valuations and are instead exploring strategies that sell single-stock volatility while buying index volatility.
The divergence between individual shares and the broader market has been reinforced by the start of the earnings season, sector rotation and significant moves within artificial intelligence-related stocks.
According to Wells Fargo Securities, options markets are pricing larger-than-normal earnings reactions for individual companies while anticipating relatively subdued moves for the S&P 500. Strategist Ohsung Kwon said AI-driven leadership changes and capital rotating between sectors have created an environment where stock-specific volatility remains elevated even as the broader index trades in a relatively narrow range.
Technology stocks have been a particular source of dispersion, with the so-called Magnificent Seven recording substantially greater realised and implied volatility than the wider market since March, after volatility linked to the Iran conflict and oil price spike eased.
Some investors remain cautious about embracing reverse dispersion too aggressively, however. UBS derivatives strategist Kieran Diamond said many managers are structuring trades with larger long positions in index volatility to limit exposure to short single-stock volatility, recognising that earnings surprises and geopolitical developments could still trigger sharp moves in individual names.
