The 10th Man

The Dispersion Trade

December 8, 2016

There is a mathematical relationship between the price of an index and the constituent stocks that comprise the index. That seems pretty straightforward.

It is also arbitrageable—if there is a price discrepancy between futures on the index and the underlying stocks, you can buy one and sell the other and make an arbitrage profit.

This is freshman year capital markets stuff.

This $5 Trillion Market Is Just Getting Started.

Don’t miss out on the ETF revolution. Get going with this must-read report from Jared Dillian.

What a lot of people don’t know is that there is a mathematical relationship between index options and options on the constituent stocks that comprise the index.

As it turns out, index options tend to be chronically overpriced, so there is money to be made by selling index options and buying single-stock options, dynamically hedging along the way. The math behind this is all pretty complicated.

The dispersion trade has been around for a while, but in the early days, it wasn’t easy to effect because of wide bid-ask spreads. There were a few floor market-makers that traded dispersion quite profitably, though, most notably, Timber Hill1.

Timber Hill had a sophisticated operation involving dozens of traders on trading floors around the world. These traders weren’t terribly sophisticated (the guy in our pit was a former construction worker), and they all had a handheld computer that just told them what options to buy or sell.

There was a giant computational engine in headquarters somewhere that identified which index options had to be sold and which single-stock options had to be bought, then fed that information to the handhelds of the traders on the floor. I’m sure they cleaned up.

At Lehman Brothers, we had one person dedicated to the dispersion trade and nothing else. She sat on the corner of the floor and talked to no one. Rumor was that she made more money than all of us put together.

So if you are a dispersion trader, you’re essentially trading correlation, which is the idea that stocks all move together or they don’t.

When correlation is high—that is, stocks are moving like a marching band—the dispersion trade is unprofitable. When correlation is low—that is, when stocks are moving all over the place—the dispersion trade is very profitable. Basically, a dispersion trader prays for the market to stand still, with giant moves in single stocks.

Which is basically what’s happening right now.

Last Chance to Get Jared’s ETF Master Class for just $99!

Many hundreds of 10th Man readers have already bought this one-of-a-kind video course that teaches you all you need to know about the treacherous world of ETFs: why they can be dangerous to your portfolio… why even professional money managers misunderstand them… and how you can make them work for you.

Today, December 8, is the last day Mauldin Economics offers Jared’s comprehensive ETF Master Class at the beta price of just $99. The offer expires at midnight, so click here to claim your copy now.

This Can’t Be Hard

I think the post-Trump environment is a pretty easy trade, but for a lot of people, it isn’t. You’ve had massive dispersion on a sector basis (financials going up, utilities going down), and for once, people have something they can trade, and they are screwing it all up.

They are not used to correlation being low. They are used to correlation being high. Meanwhile, yes, stocks are up, but not significantly—they’re statistically unchanged, and then, you have Bank of America (BAC) up 30% in a matter of weeks.

So the number one question people are asking right now is: Will this dispersion continue?

And my answer is, yes, unequivocally.

This $5 Trillion Market Is Just Getting Started.

Don’t miss out on the ETF revolution. Get going with The 5 ETF Trading Strategies You Should Know About Before Investing, from Jared Dillian.

This is the new regime; get used to it. And it is being driven primarily by interest rate expectations.

We’ve been over this before. Rates have shot up, because:

  1. Trump is going to dump supply on the market
  2. Trump is going to cause inflation
  3. Mnuchin is going to issue as much paper as possible in the ultra-long sector

High interest rates are:

  • Good for banks
  • Bad for utilities

This is a huge oversimplification, but I’m all in favor of keeping things simple.

So if that really was the turn—if we are now in a bond bear market, instead of a bond bull market—and the bear market lasts 5, 10, or 35 years…

The dispersion is going to continue.

But This Is Good News!

The last eight years have been awful, and that is not a political statement. Sure, the market went up 200%, but it was awful.

It was the toughest trading environment known to man. And it drove a lot of people toward passive strategies. Vanguard has taken in something like $270 billion this year. It’s insane.

Nothing would make me happier than an environment where some stocks go up a lot and some stocks go down a lot. This is the type of environment where an active manager or a discretionary trader can really add value.

So start adding value!

Or else you are going to simply prove what all these people have been saying for the last eight years, which is that everyone should just put their money in index funds and be done with it. Although if you really believed that, you would probably not be reading this newsletter.

I seem to remember it being easier to make money in the 1990s. I also recall that interest rates were higher in the 1990s. I think there might be a connection. So this is really like Back to the Future, in a way.

It’s been said that something like two-thirds of traders today can’t even remember a time when we had non-zero interest rates.

I remember.

I remember being able to get 6.5% in a money market mutual fund. You want to talk about easy money. You get short rates up to 6.5%, and I am going to put it all in a prime money market fund, quit writing newsletters, and live off the interest.

One postscript: I talked a lot about options in this piece, and I’m sure the whole discussion of the dispersion trade went over most people’s heads. I might teach an options course someday. We’ll see.

But in the interim, I have a book recommendation for you. I was given an advance copy of Managing Expectations by Tony Saliba, one of the original Market Wizards, which is being released next month.

When I was on the trading floor, I was raised on the Sheldon Natenberg book, Option Volatility & Pricing, but this is even better. I think it’s going to be the new standard by which all options books are judged. Check it out.

I should also mention that Mauldin’s VIP offer—get six premium services at one low price—is expiring next week. Street Freak is one of those six services, so I have a vested interest in getting you to sign up… but most of all, I think you owe it to yourself to get the widest spread of investment advice in this new low-correlation world. Get the details here.
1You might know Timber Hill by its latest incarnation, Interactive Brokers.

Jared Dillian
Jared Dillian


Get Thought-Provoking Contrarian
Insights from Jared Dillian

Discuss This

We welcome your comments. Please comply with our Community Rules.


There are no comments at this time.

Use of this content, the Mauldin Economics website, and related sites and applications is provided under the Mauldin Economics Terms & Conditions of Use.

Unauthorized Disclosure Prohibited

The information provided in this publication is private, privileged, and confidential information, licensed for your sole individual use as a subscriber. Mauldin Economics reserves all rights to the content of this publication and related materials. Forwarding, copying, disseminating, or distributing this report in whole or in part, including substantial quotation of any portion the publication or any release of specific investment recommendations, is strictly prohibited.
Participation in such activity is grounds for immediate termination of all subscriptions of registered subscribers deemed to be involved at Mauldin Economics’ sole discretion, may violate the copyright laws of the United States, and may subject the violator to legal prosecution. Mauldin Economics reserves the right to monitor the use of this publication without disclosure by any electronic means it deems necessary and may change those means without notice at any time. If you have received this publication and are not the intended subscriber, please contact


The Mauldin Economics website, Thoughts from the Frontline, The Weekly Profit, The 10th Man, Connecting the Dots, Transformational Technology Digest, Over My Shoulder, Yield Shark, Transformational Technology Alert, Rational Bear, Street Freak, ETF 20/20, In the Money, and Mauldin Economics VIP are published by Mauldin Economics, LLC Information contained in such publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
John Mauldin, Mauldin Economics, LLC and other entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest that do arise in a timely fashion.
Mauldin Economics, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Mauldin Economics publication or website, any infringement or misappropriation of Mauldin Economics, LLC’s proprietary rights, or any other reason determined in the sole discretion of Mauldin Economics, LLC.

Affiliate Notice

Mauldin Economics has affiliate agreements in place that may include fee sharing. If you have a website or newsletter and would like to be considered for inclusion in the Mauldin Economics affiliate program, please go to Likewise, from time to time Mauldin Economics may engage in affiliate programs offered by other companies, though corporate policy firmly dictates that such agreements will have no influence on any product or service recommendations, nor alter the pricing that would otherwise be available in absence of such an agreement. As always, it is important that you do your own due diligence before transacting any business with any firm, for any product or service.

© Copyright 2019 Mauldin Economics