Escalating geopolitical tensions in the Middle East are rattling one of the hedge fund industry’s most widely used options strategies, raising concerns that a sudden spike in volatility could trigger broader market disruption, according to a report by Bloomberg.
The so-called dispersion trade – a strategy that exploits the difference between volatility in a broad index and that of its individual components – has been a popular bet in recent months as the S&P 500 Index edged higher while underlying stocks moved more independently.
However, the strategy came under pressure earlier this week after the conflict involving Iran sparked a bout of global risk aversion. A key measure of implied one-month correlation surged to its highest level since November on Tuesday as both single stocks and major indices declined simultaneously.
The move highlighted the vulnerability of dispersion trades, which typically involve buying options on individual equities while selling options on the index. The trade works best when correlations remain low and stock-specific volatility diverges from broader market moves.
Hedge fund managers are particularly wary because positioning in the strategy has become increasingly crowded.
Markets stabilised somewhat on Wednesday after stronger-than-expected economic data eased investor concerns, even as geopolitical tensions continued to cloud the outlook. The CBOE Volatility Index (VIX) — a widely watched gauge of expected US equity volatility — fell back to just above 21 after spiking as high as 28 earlier in the week.
Still, some hedge fund managers believe the trade remains vulnerable if volatility persists. Alexis Maubourguet, founder and chief investment officer of Adapt Investment Managers, warned that the US dispersion trade could pose systemic risks if market conditions deteriorate further.
Signs of heightened caution are also emerging in derivatives markets. Traders pointed to the appearance of an inverted VIX futures curve earlier this week — typically interpreted as a sign that investors are scrambling for near-term hedges against potential volatility shocks.
