What Is The Implied Correlation Index?
The CBOE Options Exchange (CBOE) publishes the Implied Correlation Index, a financial benchmark that tracks the relationship between the implied volatilities of options listed on an index and the implied volatilities of a weighted portfolio of options on those index components.
This implied correlation informs traders about how closely the index components track one another and is an important piece of information for dispersion trading and delta-one strategies. Correlation indexes provide information about the relative cost of index options in relation to the prices of options on the individual equities that make up the index.
The correlation between the weighted implied volatilities of options on the index components and the implied volatilities of index options is tracked by the Implied Correlation Index.
Correlation indexes, which follow the S&P 500 and are published by the Cboe, are utilized by traders interested in dispersion tactics.
In essence, the index shows how expensive or inexpensive index options are in relation to single stock options.
Understanding the Implied Correlation Index
The correlation among index components is important for traders to understand. For instance, an index may have zero change for a day either because none of the components moved, or because half of the components rose while the other half fell. In the first case, the correlation would be very high, while in the second case, the correlation would be very low. In other words, an index can have very low volatility in and of itself, while its components may be quite volatile independently.
The Cboe introduced its implied correlation indexes in 2008 based on the S&P 500 index. The index measures the expected average correlation of price returns of S&P 500 Index components, implied through SPX index option prices, and prices of single-stock equity options on the 50 largest components of the SPX.
Each day, Cboe publishes the index values four times per minute and provides on its website the market value weights of each of the top 50 stocks in the index.
Correlation Trading and Volatility
Similar to the Cboe Volatility Index, or VIX, implied correlation tends to increase when the S&P 500 decreases. This means that stocks in an index tend to fall in tandem more than rise in tandem. While this inverse relationship to the SPX is similar, it is not as strong for the implied correlation indexes and suggests that the benefits of diversification offered by investing in broad-based equity indexes could be limited.
A long volatility correlation strategy, also known as a dispersion trade, is often executed by selling at-the-money (ATM) index option straddles while simultaneously buying at-the-money straddles in the index components' weighted options. The purpose of this method is to find a high implied correlation, which indicates that index option premiums are undervalued in comparison to single-stock options. As a result, it may be beneficial to sell index options and acquire relatively cheap equity options. Note that this is a delta-neutral approach, so market direction is not a main concern.
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