We’re living in strange times. Volatility is high, uncertainty might be higher. Old standby strategies, such as buy-and-hold, and giving way to strategies that call for a more hands-on approach to investing in exchange traded funds (ETFs). A new strategy gaining favor is that of “implied correlation.”
According to Ben Levisohn of The Wall Street Journal, stocks have been moving in virtual lockstep with each other. The situation is known as correlation, where a reading of 100% indicates that stocks are moving completely in tandem.
There are two types of correlation: actual and implied correlation. Actual correlation is based on historical data, while implied correlation is based on options traders’ expectations of correlation in the future. [ETFs: Your Friend in Volatile Times.]
Implied correlation is hovering around 80%, which means that eight out of 10 stocks in the S&P 500 will move in the same direction as the index itself. The situation is abnormal because when market volatility falls, implied correlation usually follows. Yet, despite the fact that the VIX has fallen by half over the past three months, implied correlation has barely moved.
Some professionals think the trend is temporary, and are setting up ways to profit if and when the market returns to normal. One way they are doing this is by simultaneously buying options on a stock and selling options on an ETF. The trade is known as a dispersion trade, and the bet is that the two will become less correlated over time.