A pairs trade involves two separate, yet related, option plays -- one bullish, and one bearish -- on two different underlying securities. While it can certainly be classified as a "hedged" strategy, a pairs trade is not a direct hedge in the way that a protective put shields against losses in a stock position. Instead, the concept is to play a directional trading idea while simultaneously guarding against unexpected headwinds in the given sector, or within the market as a whole.
There are several different ways to build a pairs trade, but let's consider the following example.
Widget producer XYZ is a technical standout, and you believe the near-term outlook remains bullish. However, the broader widget sector has been going through a choppy phase, with many sector components struggling in the face of weaker demand. While you think XYZ has the chops to rise higher, you're concerned the shares may fall victim to "guilty by association" selling pressure.
To hedge your bets, you decide to play a call option on XYZ while simultaneously initiating a long put on underperforming sector peer ABC. With XYZ at $35, you buy to open one 32.50-strike call at the ask price of 3.60. Meanwhile, with ABC hovering around $21, you buy to open one 23-strike put for 2.24. You've shelled out a net debit of 5.84 for both options, bringing your total cash outlay to $584 for the trade.
Your ultimate goal is to turn a profit one way or the other -- whether it be a gain on the put, the call, or both. However, both legs of the trade should be managed as one single position.
The good news is, your win rate with a pairs trade can be greater than directional plays involving only a call or only a put. However, the trade-off is that your average win will typically be smaller, due to the built-in hedge used in this strategy.
In the best-case scenario, both legs of the trade will move in your favor. XYZ rallies up to $40 by expiration, and your call is now worth 7.50. ABC drops down to $16, leaving your put option with an intrinsic value of 7.00. Both options can be sold to close for 14.50, or $1,450 -- netting you a healthy profit of $866, or 148%.
But what if only one leg of the trade pans out? Perhaps XYZ does, in fact, fall victim to sector-wide selling, and your call winds up worthless at expiration. On the other hand, ABC once again drops down to $16 by expiration, allowing you to cash in your put option at 7.00, or $700. In this outcome, you still net a profit -- albeit a much smaller one of $116, or about 20%.
Because you're dealing with two options on two underlying assets, and they're being managed as a single entity, there's no hard-and-fast breakeven point on a pairs trade. In order to win, you simply need your two options combined to gain more money than you spent to open the trade. In this example, as long as your options gain a combined total of more than 5.84 by expiration, you'll be able to walk away with a profit.
Your maximum potential loss is limited to your initial upfront cost of 5.84, or $584. In the hypothetical above, both stocks would have to move significantly against you for this to occur, since in-the-money options were used.
As with other option-buying strategies, rising implied volatility is a positive once the pairs trade has been entered, while declining implied volatility will negatively impact your position.
Since a 100% loss on a pairs trade is frequently going to be steeper than a 100% loss on a solo options play, it makes sense to focus on in-the-money options. This reduces your exposure to the ill effects of time decay, and minimizes the chances of taking a 100% loss on the position.
Managing the trade as a single position shouldn't deter you from taking profits when appropriate. If one leg is at a 100% gain, for example, you can comfortably take some cash off the table and let the remainder of the position continue to run its course.
While the scenario above discusses a trade on two related stocks within the same sector, don't be afraid to mix up your approach. Other possible pairs might include a stock and a related exchange-traded fund (ETF), or a stock and a broad-market index.
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