Latest / The Day Trading Podcast with Fexingo: Active Trading, Charts, and Short-Term Market Strategy / How Day Traders Are Using Dispersion to Profit in Low Vol
Transcript
- Lucas: So the VIX is sitting at 16, the VVIX is above 90, and the ratio between them is now above five and a half. That's a spread that day traders don't see very often, and it tells us something interesting about how the market is pricing risk. Luna: And when you say 'pricing risk,' you mean the market is calm on the surface but options traders are hedging for tail events? Lucas: Exactly. The VIX at 16 is below its long-term average around 19 or 20. That's the headline number, so most people look at that and say, 'low vol, everything's fine.' But the VVIX — which is the volatility of the VIX itself — at 90.5, that's elevated. And the ratio tells you that the options market is charging a premium for uncertainty about how much the VIX might move. Luna: Right. So the market's calm, but traders are nervous that the calm might snap. That feels like a regime where individual stocks start to diverge from each other. Lucas: That's the key insight. In a low-volatility environment where the VIX is low but VVIX is high, you tend to see correlation break down. Stocks stop moving in lockstep. That creates dispersion — and dispersion is the bread and butter of pairs trading. Luna: And we have a concrete way to play that, not just theory. Lucas: Yeah. So let's look at two small-cap ETFs. The Russell 2000, IWM, is up about 0.4% over the past five days — it's not really moving. But inside the Russell, you've got high-beta names that are swinging 2-3% a day, and low-beta names that are barely budging. If I think dispersion is going to increase, I want to be long the high-beta names and short the low-beta names — a pairs trade that is market-neutral. Luna: And you're using ETFs for that? Like, long a high-beta small-cap ETF and short a low-beta one? Lucas: Exactly. There's an ETF called SAA, which is 2x leveraged small caps — that's your high-beta proxy. And on the other side, you can use something like SMLF, which is a low-volatility small-cap factor ETF. The idea is that in a dispersion environment, the high-beta names will outperform the low-beta ones, and the pairs trade captures that spread without caring whether the overall market goes up or down. Luna: And the VVIX ratio is your signal to enter? Lucas: It's one signal. I'd look for the VVIX/VIX ratio to be above 5.0. Right now it's above 5.5. That's a threshold that historically precedes a rise in cross-sectional volatility. You can also look at the dispersion index, but we don't have a ticker for that — you'd have to calculate it yourself from the options market. The ratio is a good proxy. Luna: And what about position sizing? If the trade is market-neutral, do you still size it like a regular directional trade? Lucas: Not exactly. Because the trade is hedged against broad market moves, you can size it larger than a directional trade — but you still have to account for execution risk. The spread between the two ETFs can widen or narrow, and if you're wrong, you lose on both legs. I'd start with a position that's about 50% of your normal single-stock size, and then adjust if the ratio moves in your favor. The stop-loss should be based on the spread, not the individual ETFs. If the spread narrows by more than, say, 10% from your entry, get out. Luna: So you're measuring the spread in terms of percentage difference between the two? Like, if SAA is up 2% and SMLF is flat, the spread is 2%? Lucas: Yeah. Or you can normalise by beta. But for simplicity, track the percentage difference between the two ETFs. If you're long SAA and short SMLF, and SAA drops 1% while SMLF stays flat, the spread narrows by 1% — that's a loss. If SAA drops 2% and SMLF drops 1%, the spread narrows by 1% too. You need to watch the relative performance, not the absolute moves. Luna: And you're using options? Or just the ETFs themselves? Lucas: You can do it with the ETFs directly — that's simpler. But if you want leverage, you can use options on the ETFs. For example, buying call options on SAA and put options on SMLF would give you defined risk. The challenge is liquidity on those options. SAA options have decent volume, but SMLF options are thin. So for most day traders, I'd stick with the ETFs and size appropriately. Luna: Let's talk about the current regime specifically. The VIX at 16, VVIX at 90.5 — that's been in place for a few weeks now. Is this a trade you can hold for days, or is it more of an intraday thing? Lucas: It depends on how quickly the ratio moves. If the VVIX/VIX ratio starts to decline, the trade might unwind quickly. I'd check it at the open and then again midday. If the ratio holds above 5.0, you can hold overnight. But if it drops below 5.0, close it. The average hold time for this trade in the current environment is probably one to three days. Luna: And what if the VIX spikes? Like, if we get a sudden sell-off and the VIX jumps to 20. Does that kill the trade? Lucas: It depends. If the VIX spikes but the VVIX spikes even more, the ratio could widen further — that would actually help the trade, because dispersion tends to increase during sell-offs. Low-beta names get hit less, high-beta names get hit more, so the long-short spread would widen in your favor. The risk is if the VIX spikes but VVIX doesn't — that would compress the ratio and suggest that the market is pricing a uniform move rather than dispersion. In that case, close the trade. Luna: So the key is to watch the ratio, not just the VIX level. Lucas: Exactly. The VIX level tells you the market's view of near-term volatility. The ratio tells you whether that volatility is likely to be correlated or dispersed. And right now, the market is paying you to bet on dispersion. Luna: One thing I want to bring up — the Goldman Sachs headline on Tuesday about markets being in 'greed' mode. David Solomon said AI companies are seeking billions. Does that affect the dispersion trade? Lucas: It feeds into the narrative. When capital is flowing heavily into a few mega-cap names — AI hardware, in this case — you get a two-tier market. The big names move together, but the rest of the market starts to diverge. That's actually good for dispersion, because the small caps are less correlated with the AI names. So if you're long high-beta small caps and short low-beta small caps, you're isolating the small-cap dispersion, not trying to predict whether NVIDIA goes up or down. Luna: And the Abel headline — Greg Abel doing $17 billion in deals, expanding into tech. That's Berkshire buying tech companies. Does that change anything? Lucas: Not directly for the trade, but it tells you that big money is rotating out of traditional sectors into tech. That can create dispersion within the large-cap space too. But for our trade, we're focused on small caps. The Russell is up only 0.4% in five days, which tells you there's no strong directional bias. That's the perfect environment for a pairs trade. Luna: Let's talk about the risks we haven't covered. What about beta mismatch? If your long ETF has a beta of 2 and your short has a beta of 0.8, you're not fully market-neutral. Lucas: That's a real issue. SAA has a beta around 2.0 because it's leveraged. SMLF has a beta around 0.7. So the dollar amount you put on each leg needs to be adjusted to achieve beta neutrality. The formula is: size of short leg = times size of long leg. So if you want $10,000 long SAA, you'd need about $28,500 short SMLF to be beta-neutral. That's a big difference. Luna: That's a lot of capital for the short side. And short-selling has its own costs — borrow fees, and the risk of a squeeze. Lucas: Right. For SMLF, the borrow rate is pretty low, maybe 0.3% annually. But if you're doing this intraday, you might not even hold overnight, so borrow costs are negligible. The bigger risk is if the market rallies sharply and both legs go up — but your short leg goes up more because it's cheaper to buy. That's why beta adjustment is crucial. Luna: And you need to rebalance the position if beta changes. If SAA's leverage resets daily, its beta can drift. Lucas: That's why this is a short-term trade. I wouldn't hold it for more than a few days without rebalancing. And if the VIX starts to rise, the beta on the leveraged ETF can change because the leverage factor is based on daily returns, not long-term. So check your beta daily if you hold overnight. Luna: This is actually a really useful framework. If today's episode helped you think about a trade differently, the only reason we can keep doing these deep dives without ads is listener support. You can find us at buy me a coffee dot com slash fexingo. It's a simple way to keep the show ad-free. Lucas: Yeah, it really makes a difference. Even a few dollars helps us keep the lights on and avoid the annoying ad breaks. So if you got value from this, consider it. Luna: Alright, back to the trade. One more thing I want to touch on — how do you exit? Do you use a trailing stop on the spread, or a fixed percentage? Lucas: I prefer a fixed percentage stop on the spread. Say you enter with a 2% spread between the two ETFs. If the spread narrows to 1.8%, that's a 10% drawdown in the spread — I'd exit. That gives the trade room to breathe but caps your loss. For the profit target, I'd look for the spread to widen by 50-100% of your entry spread. So if you enter at 2%, target 3% to 4%. That's realistic in a couple of days. Luna: And if the VVIX ratio drops below 5.0, you close regardless of the spread? Lucas: Yes. The signal is the whole thesis. If the ratio drops, the environment is no longer supportive of dispersion. You might win on the spread, but you'd be relying on luck rather than the edge. I'd rather take a small loss or small profit and wait for the next opportunity. Luna: So your checklist: VVIX/VIX ratio above 5.0, enter a beta-adjusted pairs trade on high-beta vs low-beta small caps, set a fixed stop on the spread, target 50-100% of the entry spread, and exit if the ratio drops below 5.0. Lucas: Exactly. And start small. This is a sophisticated trade, and it takes practice to get the sizing right. But right now, the market is giving us a clear signal that dispersion is underpriced. It's worth a shot. Luna: And if you're watching the VIX at 16 and thinking there's nothing to do, this is a reminder that there's always a trade if you dig into the structure. Lucas: Absolutely. Low vol doesn't mean no opportunity. It just means the opportunity is in the relationships between stocks, not in the direction of the market. Luna: Great stuff. We'll be watching the ratio this week.