A Popular Hedge Fund Option Trade Adjusts to Market Volatility

Hedge funds that once relied heavily on broad index dispersion trades are now increasingly shifting toward more refined, targeted strategies. The shift comes as tariff-driven turbulence disrupts global markets, making broader macroeconomic themes more dominant than company-specific developments.

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In April, the implied correlation between stocks in the S&P 500 rose to its highest level in over two years — a time when earnings season is typically driven by individual performance. A similar trend unfolded in European markets.

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Under normal circumstances, higher correlation between index constituents weakens the effectiveness of dispersion trades — a strategy that profits from differences in volatility between a benchmark index and its individual components.

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Yet, contrary to expectations, these strategies have remained profitable. The key lies in a pivot by sophisticated investors toward smaller, more carefully selected baskets of stocks, rather than the broad market indices.

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According to Michalis Onisiforou, a flow derivatives strategist at Banco Bilbao Vizcaya Argentaria SA, dispersion trades have yielded positive returns in recent months despite the surge in implied correlations.

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He explained that many traders focused on baskets containing names with particularly high realized volatility. In Europe, volatility arbitrage (vol-arb) traders have been cashing in profits by unwinding positions in the most volatile names as the implied volatility began to drop.

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Data supports this view. A hypothetical portfolio comparing the volatility of selected Swiss financial companies to the broader Swiss Market Index showed that the realized spread widened in April — a scenario that would benefit investors pursuing dispersion strategies. This indicates that even during periods of rising correlation, careful stock selection can keep the trade profitable.

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Although the three-month implied correlation for the S&P 500 has eased slightly since its early April peak, its monthly average still stood at nearly double the one-year norm. This sustained elevation in correlation hasn’t stopped dispersion-based Quantitative Investment Strategies (QIS) from thriving. Adrien Geliot, CEO of Premialab, a company that monitors QIS activity, said that dispersion variants of these strategies performed “very well” across equity markets.

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Before April 2, investors had already been leaning toward more defensive dispersion setups. Since then, those setups have become even more important in navigating the current market landscape. JPMorgan strategists have proposed actively managed techniques to address sudden shocks in correlation — including partial intraday hedging of the short volatility leg or using VIX and VStoxx options to overlay a long volatility position.

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Bank of America strategists also weighed in, suggesting that the risks posed by tariffs — since they stem from political decisions — are both man-made and potentially reversible. Absent a significant external shock, they believe that severe market downturns (or “left-tail risks”) are less likely. On that basis, they recommended adopting a more aggressive dispersion setup with a short volatility bias.

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Interestingly, strategies that involve selling volatility — historically vulnerable to sharp market swings — have thus far weathered the recent tariff tensions with little harm. Tactical multi-strategy hedge funds took advantage of the spike in volatility in early April to enter so-called “carry trades,” which profit from selling volatility. Those who timed their entry correctly reaped substantial rewards, achieving double-digit returns in just a few days as volatility levels quickly dropped, according to Geliot.

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Still, the recent decline in volatility signals a shift in the trading landscape. The once-popular carry trade has become more focused on fixed-strike options, a development noted by Antoine Porcheret, head of institutional structuring for the UK, Europe, Middle East, and Africa at Citigroup Inc. He explained that equity market volatility has become more subdued as a result.

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“Shorting vol is increasingly being done in a risk-limited way,” said Porcheret. He added that dealers now have less exposure to volatility shifts, which makes the market less reactive during downturns. Unlike in the pre-Covid era, when volatility spikes could be prolonged, any such events now tend to be brief and less extreme.

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Overall, hedge funds are adapting to an evolving market environment by refining their use of dispersion and volatility strategies. While rising correlations would typically spell trouble for dispersion traders, savvy adjustments — such as more selective baskets and defensive setups — are allowing them to stay profitable even amid global uncertainty.

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