Sometimes, the right pair assumes a certain synergy, making the duo much more desirable than the mere sum of its parts. The same concept can be applied to one's investments; in a "pair trade" approach, 2 can truly be better than 1. As its name implies, a pair-trading approach is a dual-pronged strategy, where 2 seemingly disparate option positions are opened simultaneously. The strategy can offer somewhat of a safety net to guard against an unanticipated move in a specific sector, while capitalizing on a particular equity's relative-strength backdrop.
Essentially, a pair trader hedges his or her bets, opening positions in 2 related equities or indexes and playing them against one another, selecting 1 call (bullish) position and 1 put (bearish) position. The duo of positions then collectively enables profitable returns amid a number of outcomes.
For example, a market watcher might have a great feeling about retailing firm XYZ Shops (XYZ), but a pessimistic inkling about the summer shopping season, or he could be skeptical about biotechnology company ABC Biopharmaceuticals. (ABC) in particular but hopeful for the overall biotechnology group's short-term prognosis.
In the first hypothetical, a trader wishing to hedge against potential retailing sector weakness could play a call position on XYZ alongside a put position on a retailing index or an exchange-traded fund (ETF). The trader is positioned to make a profit if the resultant price action proceeds in either of the following ways:
- XYZ maintains its relative strength among its peers. The shares rally and the short side of the trade (the retail ETF or index) drops. Both sides of the paired trade enter positive territory.
- The entire retailing sector suffers a broad decline. The put option is profitable, counter-acting the XYZ call position, which nets a loss. This is a better outcome than if only the long XYZ position had been traded.
The Options Advantage
We've found that the flexibility and the leverage of options yield more favorable results with pair trading. Instead of engaging in the outright purchasing and short-selling of stocks (which can be pricey and ultimately carry higher risk), an options player would purchase a call and an accompanying put to initiate a pair trade. So instead of allocating $5,000 to an XYZ call, for example, the pair trader would reduce the directional risk by allocating approximately $2,500 in an XYZ call and $2,500 in an ETF or index put. The $2,500 spent on the hedged position acts as valuable insurance against a move in the wrong direction, and can end up being money well spent.
Managing the Pair
Yet another advantage to the paired-trade approach is the relative ease when it comes to trade management. If both positions move in the wrong direction, entering losing territory, it makes the most sense to close both positions. But barring this worst-case scenario, the pair can essentially be managed as a single trade, with a single combined profit or loss figure.
For example, if the long position (the call) has fallen 60% while the short position (the put) has gained 40%, the total loss on the position is 60 minus 40 divided by 2 (for the 2 positions), or 10%. As a result, even a fairly steep loss on 1 option, such as 60%, would not necessitate closing the trade, as it is offset by its counterpart. This attribute provides a cushion and some added security, giving the trader time for his scenario to play out over the lives of the options, without succumbing to stop-losses on a regular basis.
Trade Selection
A paired options trade can be initiated 1 of 3 ways:
- Buying a call on a bullishly positioned security and simultaneously opening a put on an underperforming security within the same sector.
- Buying a call on a relative-strength leader within a specified group, and simultaneously buying a put on a related sector index or ETF. In the XYZ example, a trader would open an XYZ call while also purchasing a put option on a retail ETF, such as the Retail HOLDRS Trust (RTH).
- A trader who is bearish on a particular equity can open a put while simultaneously buying a call on its related sector as a hedge against market (or sector) upside. For example, an options player bearish on XYZ would buy a put on the retailer and also open a call on a retail ETF, providing a hedge in the case of a sector-based rally.
To reiterate some of the key benefits of this concept, pair trading introduces a hedging component as protection, and it gives a trader the chance to turn uncertainty into opportunity. Using options in a pair trade is advantageous over a long/short stock approach, due to fewer dollars at risk and the leverage benefits.
