The strategy of betting on a stable overall S&P 500 index while individual stocks experience significant volatility has long been a popular and reliable approach among hedge funds.
However, as the dispersion in individual stock prices reaches extreme levels, the opposite trade is increasingly attracting investor attention.
Data from the Chicago Board Options Exchange shows an indicator measuring the expected dispersion among US large-cap stocks over the next month has climbed to its highest level since 2020, while the implied correlation between the top 50 S&P 500 constituents is nearing a record low.
Although divergence in stock performance is typical during earnings season due to varying company fundamentals, when correlation is extremely low, the entire market becomes highly vulnerable to a synchronized move triggered by a macroeconomic event.
Adapt Investment Managers is one hedge fund betting that index volatility will revert and individual stocks will begin moving more in tandem.
"The reverse dispersion trade remains a core holding for us," said Alexis Maubourguet, Chief Investment Officer at Adapt Investment Managers, in a telephone interview, noting that the traditional long dispersion trade is currently "extremely crowded."
Implied Correlation Hits Rock Bottom, Mean Reversion Beckons
The reverse dispersion trade has faced pressure this year as implied correlation has trended towards historical lows.
Maubourguet acknowledged the strategy had its worst quarter recently but remains optimistic about the current environment, believing it could deliver outsized returns if a volatility shock occurs.
"We find the reverse dispersion trade very attractive from a mathematical asymmetry perspective," he said, adding it aligns perfectly with the fund's philosophy of accepting small, frequent losses in exchange for the potential for large, asymmetric gains.
CBOE data shows three-month implied correlation dipped to a historic low of around 7% this month and remains only slightly above that level.
David Elms, Head of Diversified Alternatives at Janus Henderson Group plc, believes the reverse dispersion trade could profit if correlations revert to their historical mean.
He noted the 10-year average implied correlation for the S&P 500 is 33%, and it exceeded 80% during the COVID-19 pandemic.
"Implied correlation is effectively bounded by zero, so a long correlation trade—like a reverse dispersion strategy—has a favourable asymmetric payoff profile if correlation mean-reverts," Elms stated, making the case that the reverse trade is now "more attractive" than the traditional strategy.
With dispersion and correlation metrics at such extremes, some buy-side firms are growing cautious about the traditional long dispersion trade.
"At these levels, investors are hesitant to enter the trade, and more clients are talking about the opposite," said Mandy Xu, Head of Derivatives Market Intelligence at the CBOE, referring to shorting dispersion and going long correlation due to the extreme positioning.
AI Rotation and Earnings Season Amplify Stock Divergence
The divergence between individual stocks and the index is also being driven by the start of earnings season and investor sector rotation.
Wells Fargo Securities noted that the options market is pricing in greater volatility for individual stocks this earnings season, while the overall S&P 500 index reaction is expected to be muted.
"We are in an earnings environment where individual stock reactions are structurally more pronounced," strategist Ohsung Kwon said in an interview, adding that moves in the artificial intelligence (AI) space are a significant driver of this single-stock volatility.
"This dispersion is logical," he noted, pointing out that rotation between sectors is accelerating even as the overall index remains largely flat.
Volatility in tech stocks has been particularly pronounced in the second quarter.
Since March, both realized and implied volatility for the "Magnificent Seven" stocks have significantly outpaced that of the S&P 500, even as the initial market impact from events like tensions in the Middle East and oil price spikes has faded.
Nonetheless, some investors eyeing the reverse trade remain cautious, given that positive earnings surprises or other company-specific news could still spark sharp moves in individual stocks.
"While standard dispersion is still performing well, some investors have decided to go the other way, selling single-stock volatility and buying index volatility," said Kieran Diamond, Derivatives Strategist at UBS Group AG.
"These trades are often balanced by being structurally long the index to avoid being overly short volatility on the single-stock side," he added.
Another potential reason for the S&P 500's narrowing overall volatility is the diminishing influence of economic data on the broader market.
The dominant market narrative remains the tug-of-war between investor FOMO (fear of missing out) in AI and tech giants and risk-off sentiment.
Citigroup Inc. points out that the correlation between the S&P 500 and economic data surprises continues to weaken.
Strategist Scott Chronert wrote in a July 10 report that his "Pulse" chart "shows S&P 500 correlation to economic data surprises approaching multi-year negative territory."
Although the long dispersion trade remains popular, even as its cost of entry has risen, the extreme market levels are making the reverse strategy appear increasingly compelling.
"Every month that dispersion works successfully, more capital flows into that side of the trade," said Adapt's Maubourguet. "The setup for a reverse dispersion trade has never been as favorable as it is now."
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