Cem Karsan, founder of Kai Volatility Advisors, discusses dispersion trading, factors driving vol compression, analyzing dispersion index, risks of zero DTE options, monitoring convex moments, and impact of options expiration on market direction.
The increased issuance and popularity of structured products, combined with higher interest rates, has led to a compression of volatility in equity indexes, making structured products more appealing compared to traditional market exposure.
The dispersion trade takes advantage of the difference in volatility between an index and its individual components, allowing profit from the breakdown in correlation. While currently profitable, this strategy is crowded and reliant on volatility compression, making it potentially risky.
Deep dives
Impact of Structured Products on Volatility Market
The introduction and increased issuance of structured products, such as derivatives, have had a significant impact on the volatility market. As interest rates rise, structured products offer the opportunity to earn yields from bonds while also taking market exposure through derivatives. This increased appeal of structured products, combined with higher interest rates, has led to a compression of volatility, particularly in equity indexes. The banks issuing these structured products find themselves in a long volatility position, which they have to offset by selling volatility back into the market. This trend has resulted in increased volatility compression and has made structured products more desirable in comparison to traditional market exposure.
The Dispersion Trade and Volatility Compression
The dispersion trade is a strategy that takes advantage of the difference in volatility between an index and its individual components. When the index volatility is compressed due to the selling of volatility on the index level, the volatility of individual stocks tends to be less compressed. This difference in volatility leads to a breakdown in correlation between the index and its constituents. The dispersion trade involves shorting the index and going long on single stock volatilities. This trade has become increasingly popular and is being employed by various hedge funds and firms. While the dispersion trade is currently profitable, its crowded nature and reliance on volatility compression make it potentially risky and susceptible to potential market disruptions or breakdowns.
The Challenges and Risks of Zero DTE Options
Zero DTE (Day-To-Expiration) options, which expire within a day and have very short time frames, pose unique challenges and risks in the options market. One major issue is the lack of clear regulatory requirements for posting margin on these options. While clearinghouses may impose some margin requirements, there is still a need for more standardized regulations. Additionally, zero DTE options have a high gamma and are primarily hedged with other zero DTE options due to their fast-changing delta. This lack of hedging options outside of the zero DTE complex can create cascades wherein the demand for hedging leads to increasing gamma exposure and potentially sharp market moves within a short period. Efforts are being made to address the regulatory and structural challenges surrounding zero DTE options.
Watching Convexity and Volatility Clues
Monitoring convexity and clues from volatility markets can provide insights into potential market direction and risks. Nickel and dime options, specifically short-dated out-of-the-money puts and small VIX calls, can offer valuable signals. These options with the most convexity on the distribution tend to be in strong demand during periods of market stress and can be reflective of impending crashes or heightened volatility. Changes in the volatility supply, particularly around VIX expiration and options expiration, can also indicate shifts in market dynamics. Paying attention to these volatility clues can help identify potential risks and opportunities in the market.
On this weeks Huddle +, Kevin welcomes Cem Karsan, founder and senior managing partner of Kai Volatility Advisors. Kev and Cem take a deep dive in to all things dispersion trading!
