The concept of a stock market has been alive and thriving since the 17th century with the Amsterdam Stock Exchange taking the lead in 1602. Since then, these markets have evolved and acquired new rules along with a broad new range of securities. Indices have also developed and allow for stock markets to be measured as well as their subsets. These indices aid investors in comparing prevailing price levels with previous prices such that market performances can be calculated.
Set against this backdrop, this article seeks to shed light on the Implied Correlation Index and all that it entails.
Defining the Implied Correlation Index
Published by the Chicago Board Options Exchange (or CBOE), this index serves as a financial benchmark. It is responsible for keeping tabs on the correlation that lies between implied volatilities of options that feature on an index and the implied volatilities of weighted portfolios of options pertaining to the components of the aforementioned index.
The implied correlation is relevant to traders as it indicates how narrowly the index components track against one other. It provides crucial information such that dispersion trading and delta-one strategies make use of. With a correlation index it is possible to acquire insight into the relative costs associated with index options in contrast to the prices of options on individual stocks that make up an index.
Correlation allows financial investors to gain insight into the diversification benefits they can acquire while creating a portfolio. Low correlation minimizes a portfolio’s overall volatility further than the weighted average volatility of a portfolio’s component stocks. As a result, investors can stand to gain superior risk/ return trade-offs. Positive rises in correlation stand to minimized an investor’s realized diversification benefits and also indicate greater systematic risk. With correlation, it is possible to have the likelihood of extreme tail events being tethered to sudden market movements be quantified.
Assessing all that the Implied Correlation Index Entails
It is important for traders to be able to grasp the correlation that exists among index components. Take for instance the fact that the index features no change for a day. This could either be owed to none of the components moving or because half of the components witnessed a hike while the other half witnessed a decline. In the case of the former, the correlation would be extremely high whereas in the case of the latter it would be extremely low. This means that while an index can exhibit low levels of volatility in and of itself, its components may exhibit high levels of volatility independently.
The Chicago Board Options Exchange brought forth its correlation indexes in 2009 in accordance with the S&P 500 index. These indexes are responsible for measuring the anticipated average correlation of price returns pertaining to S&P 500 Index components. This is implied via the SPX index option prices along with prices of single-stock equity options relevant to the 50 biggest components of the SPX.
The CBOE published index values four times each minute on a daily basis. Its website features the market value weights pertaining to every one of the top 50 stocks relevant to the index.
The CBOE correlation indexes presently have three expiration cycles featured below the tickers: KCJ, ICJ and JNJ. These symbols rotate in accordance with the expiry of options keeping in mind their maturity dates.
Correlation Trading and Volatility
Akin to the CBOE volatility index, implied correlation tends to increase in diametric opposition to the S&P 500 index i.e., when the SPX declines. This implies that stocks featured under an index are more likely to fall in tandem as opposed to rising in tandem. Although this inverse relationship to the SPX is akin, it isn’t as apparent for implied correlation indexes. Furthermore, it implies that the advantages of diversification brought by investing in broad-based equity indexes could be narrower than previously imagined.
Ordinarily, a dispersion trade (also known as a long volatility correlation trade) is garnered by selling at-the-money (or ATM) index option straddles. This is accompanied by the simultaneous purchase of at-the-money straddles in the options of the index portions of a weighted basis. The mission of this strategy revolves around the identification of instances of the implied correlation being high. This indicates that the index option premiums are overvalued in contrast to single-stock options. Owing to this fact, selling the index options and buying comparatively undervalued equity options can prove to be profitable. This is a delta-neutral strategy owing to which the direction of the market isn’t one of the most pressing issues.
Diversification is not Static
When looking at financial markets it is important to understand that a given portfolio’s risks can be sliced into systematic factors along with diversifiable risks. Investors can avoid great risk exposure without adversely affecting their returns by creating a broad enough portfolio. This portfolio can be made up of diverse securities that each have different risk drivers.
Set against this backdrop the SPX Index is often looked at as the premium target portfolio capable of providing investors with the most consistent risk-return profiles. That being said, whether or not the SPX index truly guarantees diversification benefits for all risk types can be assessed by looking at the relationships between index components and their evolution due to changes in correlation.
A wide range of applications in finance makes use of correlation estimates. These include but aren’t limited to capital allocation, option pricing and hedging, risk management and asset pricing models.