Q and A. Pairs Trading Using Options

Hi Mark,

I was wondering if you have any thoughts about pairs trading?  

[An investment strategy that seeks to identify two companies with similar characteristics whose stocks are currently trading at a price relationship that is out of their historical trading range. Investment strategy: buy undervalued security, sell short overvalued security.]

I got turned on to this strategy before the ’08 decline, and subsequently watched my friends and family lose half of their portfolios over the past year.  Now I’m less inclined than ever to own “naked” stocks. 

I like the idea of getting into covered calls (if I can find a stock I’m comfortable owning) and eventually condors, collars and other hedged, short-term investments.  Pairs trading is one of my favorites so far, and since options seem to be your primary focus, do you have an opinion on how I might be able to incorporate short options or spreads into this type of strategy?  I’ve considered buying a call on the undervalued stock, and buying a put on the other stock, but my back-tested returns are not very consistent using long options.  Any insight would be appreciated.

I think pairs trading is one of the better alternatives in this market.  Better than buying indexes (certainly not many individual stocks) on the hopes that some kind of bottom is near or shorting on the hopes that the slide will go on just a little longer.  As you’ve said, “Hope is not a strategy”. 

I only use it on pairs with the strongest historic correlations (at least 97%) and I wait for a nice 2.75 – 3 standard deviation divergence before entering…Another important point, that I suppose holds true for most strategies, is not chasing those last nickels.  While I assume that each pair is going to revert all the way to its mean ratio, it’s a lot more comforting to exit before then, like when it comes back down to 1 standard deviation, and get a smaller, more consistent profit.  Just my observations so far…there’s still plenty more for me to learn.  But wouldn’t it get a little boring otherwise?

Martin

Hello Martin,

I have never tried pairs trading, but can tell you that I don't like the idea of buying calls on one stock and puts on the other.  This does not really give you the play you want because it depends on a substantial move to earn a profit.  Both options can easily expire worthless.

I'd rather sell option premium.  Whether to sell naked options (far riskier) or spreads is a decision that should be easy to make based on the boundaries of your comfort zone.  Your idea of writing covered calls is, as I am sure you know, equivalent to writing naked puts.  That suggests to me that you may prefer to write naked options, but that gives me the 'willies' in this volatile market.

There is a big potential problem when you sell premium. If both stocks undergo a large move in the same direction, and if you are correct and your long position rallies far more than the short position, you can lose money when trading options in place of stock.

For example, if you sell a call spread and put spread in the above scenario for $2 each, the put spread would move to zero.  That $200 profit would be less than the $300 (or $800) potential loss (depending on whether you sold a 5- or 10-point spread) that results from the call spread.  True, good risk management would reduce the loss, but if trading pairs, you don't want to lose money when you are 'right.'  And that risk is ever present when you sell option premium:  a large market move is a problem.

Alternatives

If you are willing to exercise a bit of imagination, you can trade iron condor positions. 

For example, for your undervalued stock, sell 10 put spreads and 5 call spreads (or any other quantities that work for you).  That's an off-balanced iron condor with a bullish bias.

For the overvalued stock, you can sell 5 put spreads and 10 call spreads. 

You may still incur a loss if the stocks move too far, but this is safer than selling naked options.  It also has this advantage:  If the stocks move higher, you are short fewer call spreads in the stock you think will have the larger upside move.  And if these stocks head lower, you are short fewer put spreads in the stock that you believe will under-perform.  I've never tried any of this, but it seems to be a reasonable play.

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