I was wondering if anyone had any insights regarding the optimal method of hedging deltas within a dispersion strategy. My first instinct would be to hedge on a daily basis, given that correlation data woudld be calculated off of daily returns. Or, maybe the best method would be to hedge long gamma positions based on the implied volatility daily standard deviation moves, and hedge short gamma positions daily. I can't seem to find any information on this anywhere. Thanks in advance.

There isn't really any general rule here.You can try and look for patterns in historical volatility, such as weekly vol being different from daily vol, and try to optimise things that way. I've never found these patterns to be very stable for very long.But dispersion trades are actually tricky to get right if done with options. As the stocks drift around, you find that the moneyness of the options drifts out of alignment, and you have gamma exposures that you either run or cut (which costs).In recent years it has been possible to run dispersion positions using variance swaps. You put these trades on and just sit back and watch!As regards papers, dispersion trades have been around since the late 1980s and early 1990s, so I would imagine something has been written somewhere!

I've heard about the problem with the options drifting out of alignment. Pardon my ignorance, but what are variance swaps? I've never heard of these - are they liquid enough to trade?

dude - you are talking to the right guy! my one claim to fame is that i am the grandfather trader of variance swaps - we dealt the first one in 1993. but i give full credit to the client for inventing it, and massive credit to the sophisticated marketers who could understand and sell it back then.a variance "swap", annoyingly so-called against my will by a marketer in that company, is actually a forward contract.the settlement price of the forward contract is normaly determined at the end of the contract's life by the daily historical closing prices of the underlying stock, index, currency, etc.the formula used for settlement looks very much like the standard definition of variance, with some minor adjustment.there is a strike price when you deal the swap, for example 13% on the eurostoxx 50. the 13% is what is quoted but the actual strike is 0.13^2, as the variance is the square of the volatility.so the contract is normally dealt with zero upfront payment, and the payoff function (if you bought variance) would look like this:payoff = "variance units" * ("final variance" - "variance strike")if the realised variance from the historical data is higher than the strike price, the variance buyer profits.you can see that it is quite easy to calculate the vega of a variance swap, and the swap is often dealt in vega amounts like $100k per volatility point. the vega obviously is a function of the vol level, so this vega amount refers to the vega at the strike price.variance swaps are quoted on many underlyings in equity as well as in FX.options on variance have been dealt on SPX, eurostoxx50 and FTSE-100 to my knowledge, with at least three banks quoting prices and about five more ready to join the party.

erstwhile,do you mean that variance swaps are quoted on all underlyings of EuroXX50? for the dispersion trade you will need those as well, I suppose, or do you only take away the drift risk on the index side?

yes, you can trade a package of 51 variance swaps, one on the index plus 50 individual stock variance swaps, which thereby cover the entire eurostoxx 50 index.this can no doubt be done on the dow as well.both stock and index var swaps would normally be capped (i.e. there is a max payout) in case of giant corporate events or surprise defaults, to avoid blowing up one of the var swap counterparties.more interesting than var swaps are options on var swaps (meaning not way OTM options that appear to be worthless). the modelling for this was cracked fairly recently. i think it is a great product and will expand rapidly in the near future.

erstwhile, thanks for sharing your thoughts and all your comments!! I will have a close look to variance swaps for any mispricings...

sure bid offer would kill you on - index's are prob about a vol to a vol and half wide, single stocks a vol and half wide in liquid names maybe two - surely thats enough to take push risk/reward beyond most clients?

...

more like half a vol point for index var swaps for liquid maturities (not 3 week and not 3 years). and that is from one broker - check 5 brokers and you get a much tighter market. a few days ago i could have crossed two brokers in the SX5E variance swap market!

whats an SXE5 variance swap.

a variance swap on DJ Eurostoxx 50 index.

Quotemore interesting than var swaps are options on var swaps (meaning not way OTM options that appear to be worthless). the modelling for this was cracked fairly recently. i think it is a great product and will expand rapidly in the near future.erswhiledo you have a specific publication in mind on that interesting subject?e.

i wish i did have a publication i could pass around, but i 'm not sure anything has been published yet!if anyone else can post something on the pricing of options on var/vol it would be appreciated.the guy who first cracked options on vol/var is a friend of mine currently trading at merrill.other people who definitely can price options on var swaps are bank of america, citigroup, deutsche bank. others who are coming on line in the near future include soc gen, jpm and bnpp. apologies to those left out.what is funny is that my friend at merrill worked out a good way to price/hedge these things, and ML tried to get some trades on. but it was no dice! people wanted to get a price from more than one bank, and wanted liquidity from other banks in case they wanted to exit the trade. nobody would trade, so my friend realised that the only way he was going to make money on this product is if he gave away his pricing methodology! he did so and now people are getting up to speed.i am an end user, not a market maker.

the only publication I know of is this onehowever I found it too theoretical & obscure - in particular I am unsure whether the assumption of dynamically trading the underlying and a variety of options is realistic in terms of transaction costsI didn t know the story about options on var/vol & I didn t know there was a real market in place eitherI will check around...e.