Dispersion Trades Come into their Own Amid Sell-off in Tech Stocks
On Monday 27th January 2025 global investors dumped tech stock as a new player from China called DeepSeek, emerged in the AI (artificial intelligence market) threatening the dominance of the United States as companies such as Nvidia had a record one day loss of circa USD593 Billion. Other major shares tumbled such as chipmaker Broadcom down 17.4%, Alphabet fell 4.2%, and Marvel Technology fell by 19.1% to mention but a few. The catalyst for this fall was DeepSeeks AI model named RI which by all accounts uses less data at a fraction of the cost compared to that of the competition.
Many hedge fund traders saw an opening for dispersion trades which buys options in single stocks and sells contracts on an index and as such this trade had its best day since 2020 as fears for A! spread through the market like wildfire. The dispersion trade therefore is a bet on an index remaining calmer than its individual stocks. Once the domain of the hedge funds, the dispersion trade is now offered by banks to their clients which they have packaged into easy to access swaps. The Cboe S&P 500 Dispersion index* enjoyed its biggest gain since 2022.
*Cboe S&P Dispersion Index – This index may provide an indication of the markets perception of the near-term diversification or equivalently, an indication of the markets perception of the near-term of idiosyncratic risk in the S&P 500’s constituents. In simple terms dispersion refers to the range or spread of individual stock returns around the index’s average return.
Essentially dispersion trading is a form of arbitrage, specifically volatility arbitrage which as mentioned above is betting on the volatility of individual stocks against a more placid index where the stocks are quoted. A simple explanation of arbitrage is the selling and buying of the same stock, currency, or commodity at the same time in two different markets but where there is a small price differential. The profit between buying at the lower price in one market and selling at the higher price in another market is known as arbitrage trading.
Elsewhere, the sell off in tech stocks benefited a number of quant trades where the trading model is going long on some stocks and short on others. This is a strategy that buys steady stocks and sells the opposite (in this case tech stocks) which according to analysts jumped the most since 2020. Again, when the two positions are traded out the profit (or loss) is the arbitrage from the two trades.
