Abstract
Several trading institutions are actively engaged in ‘volatility dispersion’ strategies. These involve selling volatility on the index and buying volatility on the components. This trade was traditionally done using at the money (ATM) straddles. An important practical problem with this approach is that market prices move and cause the original ATM options to become out of the money (OTM) and lose their vega exposure. Even if volatility moved as expected by the trader, the profit potential of the trade would be greatly diminished as the options lost their vega. To correct this problem, a new style of trading has emerged in which some practitioners are trading this strategy using a ‘variance swap’ approach. This has the advantage that both legs of the trade have relatively constant vega exposure, regardless of stock market movements.
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