SG Corporate & Investment Banking, JPMorgan and Citigroup have started to offer instruments in Europe that allow investors to punt on the volatility of a stock, the relative value of two stocks or a series of stocks against an index, without the hedging problems associated with using options.
The trades are popular now because single-stock implied volatility looks cheap compared to index volatility and this, says Jim Neave, head of European flow equity derivatives trading at Citigroup in London, makes so called 'dispersion trades' attractive in the near term. In a dispersion trade, an investor takes a view on the realized volatility spread between an index and the average of its component stocks or the realized correlation between the constituents.
The popularity of index variance swaps last year, resulting from high equity volatility, has spilled over into demand for similar instruments on single stocks, said Alastair Beattie, head of the hedge fund group at SG CIB in London. "The single-stock variance swap market is still in its infancy in Europe," he continued, adding that the market is more developed in the U.S.
Clemens Lansing, managing director and head of flow derivatives-Europe at JPMorgan in London, described the single-stock variance swaps market as small but increasing and said it could expand to include plays on sector volatility.
Most top-tier houses offer variance swaps on equity indices but only a few offer variance swaps on single stocks, noted Beattie. Single-stock variance swaps are more difficult to hedge and are less liquid. These instruments are typically used by hedge funds to express a view on the volatility of a stock but can also be used in combination with an index variance swap for dispersion trades.
Views on the volatility of stocks versus an index have typically been expressed by selling index options and buying stock options. But variance swaps isolate the volatility without the hedging problems associated with options and so are more efficient.
