Dispersion Trading : Construction and Evaluation

Abstract: Since the introduction of derivatives into the modern financial market, volatility based tradingstrategies have emerged as important tools for asset managers. Since the financial crisis apopular trading strategy has been dispersion trading, however few published studies ofdispersion trading exist. This thesis aim to perform a study of how dispersion strategies performand their characteristics. This is achieved by finding basic common dispersion trading strategies,isolate and evaluate their attributes to then draw conclusions in general about dispersion trading.Three basic dispersion strategies are found based on vanilla option spreads and their performanceis back-tested. It was found that the strategies delivered positive return with low marketcorrelation and acceptable risk. It is also found that transaction costs is a key-factors tosuccessfully use dispersion trading. Thus it is a vital factor to consider when creating adispersion based trading strategy. An interesting topic for further research is how trading signalssuch as the implied correlation and the implied volatility spread can be used to increaseprofitability. As well to model market impact from dispersion trading.