Dispersion trade has become one of the most popular strategies among Wall Street hedge funds. Now, some investors are choosing to bet in the opposite direction.

Since early August, the U.S. stock market has appeared relatively calm, with 60-day realized volatility falling to its lowest levels since before the pandemic outbreak. The Chicago Board Options Exchange Volatility Index (VIX), a commonly used gauge of market volatility, has hovered below its long-term average of 20 since mid-June. However, beneath this calm surface, undercurrents are stirring as individual stocks experience dramatic swings—Oracle's 32% surge over the past month being just one example.

This environment has prompted hedge funds to increase their bets on overall market tranquility while individual stocks experience significant volatility. As long as the S&P 500 moves slowly upward within a narrow range while individual stocks diverge, this strategy can generate returns, though profit margins are shrinking.

Benn Eifert, Executive Partner and Co-Chief Investment Officer at hedge fund QVR Advisors, says the trade has become "extremely crowded." "Large multi-manager funds (pod-shops) are conducting massive dispersion trades."

About six weeks ago, his fund decided to go against the trend by executing reverse trades. Eifert notes that the difference between individual stock implied volatility and index implied volatility has approached "historic highs." "We did indeed execute reverse dispersion trades: long index volatility, short individual stock volatility."

His contrarian approach reflects the challenges fund managers face in dispersion trading. Individual stock options have become relatively expensive, while the premium earned from selling index options is limited.

"There's definitely structural volatility supply, which we believe has a suppressive effect on the market," said Greg Boutle, Head of U.S. Equity and Derivatives Strategy at BNP Paribas.

This doesn't necessarily mean selling index volatility is a bad idea, as this situation could persist for an extended period.

"These phenomena can last much longer than you might expect," Boutle referenced the 2018 "Volmageddon" event, when the VIX spiked dramatically after 18 months of low volatility.

To some extent, index calm may be related to significant individual stock volatility. If one company's stock surges 20% in a single day while another similarly-sized company's stock falls by the same magnitude, the net effect on the S&P 500 would be zero.

QVR's reverse strategy also has drawbacks. Eifert points out the strategy carries "idiosyncratic loss risk," which is triggered when individual stocks experience significant gains, such as recent surges in Oracle or Intel.

Not everyone believes adopting reverse dispersion trades is wise.

"Despite looking attractive, investors remain hesitant," said Amy Wu Silverman, Head of Derivatives Strategy at RBC Capital Markets. "Many investors learned lessons from the meme stock rally and are reluctant to interfere with right-tail events," she added.

Reverse dispersion trading "is essentially a long correlation trade, fundamentally a bet on market decline," noted Alex Altmann, Global Head of Equity Tactical Strategy at Barclays.

Altmann believes now is a poor time to short the market. "I would use low volatility to buy call options rather than put options."