2.4.4 Index Dispersion

After the rise of volatility products, participants became aware of an interesting arbitrage between the IV of index options and the IVs of the underlying stock options that make up the index. Generally, the volatility of the index tends to be lower than the volatility of the underlying components, so many strategies try to capitalize on this difference via dispersion trading, where they go short vol on the index and long vol on the individual underlying stocks. This strategy is evident through most of 2023 and 2024 on the SPX, where participants were short index vol and long vol on the Magnificent 7. Because of this dynamic, it can be common to see constituents of an index move more than 5% relative to each other while the index remains nearly flat.