Implied Correlation Index: What it Means, How it Works

What Is the Implied Correlation Index?

The Implied Correlation Index is a financial benchmark published by the Cboe Options Exchange (Cboe) that tracks the correlation between implied volatilities of options listed on an index and the implied volatilities of a weighted portfolio of options on the components of that index.

This implied correlation tells traders how closely the index components are tracking against one another and is a crucial piece of data for dispersion trading and delta-one strategies. Correlation indexes essentially offer insight into the relative cost of index options compared to the prices of options on individual stocks that comprise the index.

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 actually 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 exhibits a tendency 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.

Commonly, a long volatility correlation trade, also known as a dispersion trade, is achieved by selling at-the-money (ATM) index option straddles and simultaneously buying at-the-money straddles in the options of the index components on a weighted basis. The goal of this strategy is to identify when implied correlation is high, indicating that index option premiums are overvalued relative to that of single-stock options. Therefore, it could be profitable to sell the index options and buy the relatively undervalued equity options. Note that this is a delta-neutral strategy, so the direction of the market is not a primary concern.

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