On a day of historically sharp declines in the stock market, you will hear many people offer many neat reasons why the Dow Jones Industrial Average declined by almost 1,000 points.
There are rumors of hedge funds in trouble circulating the Street, and it is likely that many investors suffered margin calls, which typically hit the market at around 2 p.m.
One factor that you will not likely hear discussed is that many, if not all, major banks with trading operations operate something called “dispersion books.”
It is always silly to cite one factor to blame for the stock market’s woes, but the dispersion books could have a major impact. The so-called books offer investors the opportunity to profit on the differences in volatility between index options and their component stocks.
Until recent days, and especially today, investors could sell low index volatility and buy stock options with higher volatility. The dispersion refers to the difference between index and stock options volatility. This trade was fairly profitable because index volatility has steadily declined – the Chicago Board Options Exchange Market Volatility Index (VIX) peaked at about 90 in October 2008 and just last week was around 17 – while stock option volatility has more or less increased.
When you hear people say it’s a stock pickers market, as they were until recently, that is when “dispersion” trades kick in. Admittedly, dispersion trading is some pretty esoteric stuff. Unfortunately, it is also the stuff of big money investors, and many banks have ramped up “dispersion” books to take advantage of the perceived economic recovery.
The VIX was recently up 41% – and I cannot recall a sharper move in recent memory – at 35.26.
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