In a Classic Dispersion Trade, how is the position structured?

In a Classic Dispersion Trade, the position is structured to capitalize on the difference in volatility between individual stocks and a broader market index. This strategy typically involves taking a long position in options on individual equities while simultaneously shorting index options.

The rationale behind this approach lies in the expectation that the volatility of the individual stocks will be higher than that of the index. When the market perceives higher volatility in the individual names than in the index, the trader stands to benefit from the relative movement. By going long on options of individual stocks, the trader is positioned to benefit from any favorable price movement or increase in volatility in those stocks.

Conversely, shorting the index options serves the purpose of hedging against the overall market risk. If the market behaves as expected and individual stocks exhibit greater volatility, the long options positions will gain in value while the short index options may lose less, allowing the trader to profit from the difference in performance. This strategy thus effectively captures the expected divergence in volatility, reinforcing why this structure is the hallmark of a Classic Dispersion Trade.