Hedge funds pile into Japan dispersion trade

Recent increase in single stock option issuance driving the market in dispersion trading

Increasing retail appetite for single stock uridashi structured products in Japan has driven a spike in dispersion trading by hedge funds as dealers look to the sector as a way to hedge their long vega positions.

The 2013 bull market phase of Abenomics saw the benchmark Nikkei and Topix indexes rise by more than 70%, whereas this year they are both roughly flat following a period of volatility early in 2014. However, some single stocks have continued to flourish – particularly those with an export focus. Panasonic, for example, has seen its share price increase by 24% over the past 12 months.

Dealers say that as a result hedge funds have been entering into dispersion trades to take advantage of this more diverse market performance. A dispersion trade takes advantage of relative value differences in implied volatilities between an index and a basket of component stocks, looking for a high degree of dispersion. If maximum dispersion is realised, the strategy will make money on the long options on the individual stocks and will lose very little on the short option position on the index, as the latter would have moved very little. The success of the strategy relies on buying cheap volatility and constituent stocks that are likely to disperse.

While the overall amount of uridashi business has declined this year, the relative market share of its single stock variant has increased dramatically in 2014.

"The equity uridashi business is a third the size of last year but the proportion of single stock volatility versus index volatility is much bigger. As there is more single stock volatility in the market it becomes appealing to buy it due to its relative cheapness and then sell index volatility," says Naohide Une, head of equity derivatives at Goldman Sachs in Tokyo.

The dispersion trade looks attractive for the six months or longer bucket as single stock volatility is very dislocated

Dealers estimate that single stock uridashi now represents 25% of total volumes, up from 15% a year earlier. Indeed, Nicola Pantone, Hong Kong-based head of institutional equity derivatives sales for Asia-Pacific at HSBC, says that September also saw the highest volume of single stock uridashi issuance since the dotcom boom.

Asoka Woehrmann, chief investment officer at Deutsche Asset & Wealth Management in London, says this pattern is reflective of a cyclical change in the Japan equity story.

"Japanese equities are still closely correlated to moves in the dollar/yen rate, but the speed of further rises in the Nikkei is fading. The first phase was buying the market via the index followed by sectors and it's now moving to a stock specific play. Cyclical sectors still have some momentum and small and mid-cap stocks are an interesting segment."

Pantone says it is exactly this pattern that makes it timely to trade dispersion. "The Nikkei performance this year has not been great with a lot of sector rotation. We have noticed a shift in investment strategy from macro directional trading into sector and stock picking as a better way to generate alpha. Such a shift into stock picking has been reflected in a collapse of Nikkei 225 realised correlation," he says.

In early 2012, the Nikkei 225 had a 60-day realised correlation averaging 35–40% which subsequently spiked to 80% in June 2013 during the peak of the Japan rally.

Dealers estimate there may be $3 million–$4 million of single stock vega in the market compared with $25 million–$30 million of index vega but the single stock vega is potentially more valuable in the current market environment.

"The dispersion trade looks attractive for the six months or longer bucket as single stock volatility is very dislocated. Pricing of single stock vol versus index correlations is above 70% which is high, so it makes sense to buy single stock vol and sell the index," says Une.

As single stocks are displaying, on average, higher implied volatility than the index, it translates into higher coupons and bigger demand for single stock uridashi, hence a pick-up in single stock implied volatility supply in the market. Typically index uridashi is paying around 2.5% coupon versus double or more for the single stock version.

Dealers also say that some banks such as Barclays and UBS have less risk appetite and may be reducing inventory by selling single stock volatility after a disappointing Japan equity performance this year.

Dispersion strategies become very risky when liquidity tightens in the options market as it can become difficult to exit the trades; this becomes acute when the market moves violently in a particular direction, according to one major international dealer based in Tokyo which has not been active in the trade lately due to risk management concerns.

"We view volatility swap dispersion packages as a dangerous way to hedge single name uridashi risk, the reason being that as soon as spot moves meaningfully away from the original strike the dealer is short vega in one direction. And in an extreme scenario when this happens very quickly, spot and volatility rise in tandem, meaning dealers get hurt as they are short volatility. This is exactly what we saw at the end of 2012 and early 2013."

According to the major international dealer, moves by firms to recycle their exposures via dispersion trades are driven not by risk management principles but desperation.

"Dealers trade dispersion not because they see it as the best way to recycle risk but as a last recourse option if they have so much vega risk in the book and have tried selling vanilla options and everything else. It is like a last ditch effort to de-risk, especially if you have your risk manager breathing down your neck. It's imperfect but the only option out there," he says.