Popular Hedge Fund Options Strategy Attracts Contrarian Bets

The dispersion trade has quietly become one of the most widely used strategies among Wall Street hedge funds. But now, a few bold investors are flipping the script and taking the other side of the bet.

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On the surface, the U.S. equity market looks unusually calm. Since early August, 60-day realized volatility has dropped to its lowest level since before the pandemic. Meanwhile, the Cboe Volatility Index (VIX), Wall Street’s “fear gauge,” has been pinned below its long-term average of 20 since mid-June. Beneath that calm, however, individual stocks are swinging wildly Oracle Corp.’s 32% surge over the past month is a prime example.

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This split has fueled the rise of dispersion trades. Hedge funds are betting that index-level volatility will stay muted while single-stock volatility stays high. As long as the S&P 500 continues inching upward in tight daily ranges while individual stocks trade in different directions, the strategy delivers profits. But as more money piles in, the margins are getting thinner.

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The trade has become “extremely crowded,” said Benn Eifert, co-CIO at QVR Advisors. “There are massive dispersion trades by the big pod shops.”

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Roughly six weeks ago, Eifert decided to go against the crowd. With the gap between single-stock implied volatility and index implied volatility near record highs, he flipped the bet. “We’re long index vol and short single-name vol,” he explained, calling it a reverse dispersion trade.

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The problem for hedge funds sticking with the traditional approach is that single-stock options have become expensive, while selling index options doesn’t offer much premium. “There’s definitely structural supply of volatility and we think that has a depressing impact,” said Greg Boutle, head of U.S. equity and derivatives strategy at BNP Paribas.

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Still, history shows that quiet markets can last much longer than most expect. “These things can persist a lot longer than you think,” Boutle added, pointing to the 18 months of subdued volatility that preceded 2018’s “Volmageddon,” when the VIX suddenly spiked.

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In some ways, the calm in indexes is linked to the chaos in single stocks. If one company rallies 20% while another of similar size plunges the same amount, the two moves cancel each other out in the S&P 500, leaving the benchmark steady.

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Of course, betting on reverse dispersion carries its own risks. Eifert acknowledges that the position has “idiosyncratic loss exposure” when an individual stock makes an extreme move, such as Oracle or Intel’s recent sharp gains.

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Not everyone is convinced that turning against dispersion is wise. “While it looks attractive, investors are still hesitant,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. She pointed out that many traders still remember the post-tariff “Liberation Day” rally in April and don’t want to be caught on the wrong side of another right-tail move.

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Alex Altmann, global head of equities tactical strategies at Barclays, also raised doubts. He argued that reverse dispersion effectively amounts to a “long correlation trade,” which is often a bet that markets will head lower. “I think it’s a terrible time to be short stocks,” Altmann said. “I’d use low volatility to buy calls, not puts.”

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Stock selection also plays a crucial role in dispersion trades. At QVR, Eifert builds baskets of 125 to 150 large-cap names to balance his contrarian approach.

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Other strategists have experimented with different baskets. In July, Barclays’ Stefano Pascale suggested applying dispersion trades to meme stocks. One tool for doing so is the Barclays Equity Euphoria Indicator, which uses options activity to identify the market’s most speculative names the kind that often skyrocket before crashing.

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This method helps traders avoid overconcentration in mega-cap names like Tesla and Nvidia, which dominate many hedge fund strategies. The ongoing AI frenzy, for instance, has been creating pronounced volatility in smaller, less profitable tech companies.

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“You really need to zoom in on smaller stocks,” Pascale said. “You probably want to buy volatility on the names flagged by the Euphoria Indicator and sell it on the others.”

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