Jason Goldberg, Portfolio Manager at PIMCO and Marko Kolanovic, Global Head of Quantitative and Derivatives Strategy from JP Morgan teamed up this morning atCBOE's Risk Management Conference (RMC) in Carlsbad, CA for a presentation billed as Correlation Between Stocks and Between Sectors. This presentation was a combination of educational and informative, discussing what traders can learn from trading in correlation and dispersion along with analysis of recent correlations across different markets.
Jason Goldberg’s part of this session noted that index option volatility is rich while individual stock option implied volatility is ‘less rich’. Combining these two can involves selling the rich index volatility and purchasing the less expensive individual stock volatilities. He got a Sean Connery reference in which amused the group, saying 'we know where Correlation is, but how do we make money with it"? He finished up with six rules for option traders –
- Greeks are only local measures of risk
- Premiums don’t lie, but the Greeks can
- Don’t confuse volatility trading with directional trading
- The path matters
- Good systems are critical – but you need to be able to handle lots of data
- Explain, explain, explain your P&L
Marco spoke about Realized Correlation and Drivers of Correlation. He compared indexes to individual stocks and noted that correlation has been trending higher over time. Does one use daily data, weekly data or other time frames? His chart compared a 3-month look back to a 1-year, the shorter term was much spikier.
One driver of correlation is that Index futures, options and ETF's volume (as a % of market) mechanically increasing correlations.
Correlation Risk Premia - implied correlation trades at a premium to realized, Correlation is convex. Index options can be more expensive than sector options, so a spread between the two could be an interesting trade. Term and Skew correlation premia has increased, but difficult to monetize correlation.
Implemation alternatives include:
- Correlation Swaps
- Variance Swaps
- Volatility Swaps
- Straddles / Strangles / Calls / Puts
- Proxy Baskets
Marco asked - what should the ratio of stock to index Vega be? This led to the Q & A section at the end of the talk. Over 100 attendees in this breakout section enjoyed it very much.