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The key to correlation trading is understanding the principle of diversification, which implies that the volatility of a portfolio of securities is less than (or equal to) the average volatility of all the securities in that portfolio (based on Modern portfolio theory). The lower the correlation among the individual securities, the lower the overall volatility of the entire portfolio. This is due to the way in which variances behave when summing correlated random variables.
To buy correlation, investors can:
- Buy a call option on the index and sell a portfolio of call options on the individual constituents of the index;
- Buy a variance swap on the index and sell the variance swaps on the individual constituents; this particular kind of spread trade is called a variance dispersion trade.
- Buy a correlation swap.
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