Advanced Trading Center

Pairs Trading - An Option-Buying Strategy for an Uncertain Market Environment

Senior Vice President of Research Todd Salamone crafted this report on the Pairs Trading strategy for SchaeffersResearch.com. It originally appeared as a five-part series in August 2006.

Introduction to Pairs Trading

No doubt that 2006 (like 2005) has been a challenging market environment for the option-premium buyer, where directional trends become a major tail wind for bottom-line success and range environments become head winds. A range-bound environment as a result of vicious sector rotation has made it tough to achieve the big home-run type trades that are critical to profitability for the aggressive option buyer. During the past couple of years, I've had a mix of success and disappointment in the option-buying world. Overall, though, the lack of consistency relative to previous years has been very frustrating.

In doing an analysis of my trading, a couple of comforting factors came to light:

1. I can find volatility, and
2. I can pick the relative-strength leader/laggard within a group

It is getting caught up in unexpected, short-term sector rotation that has made for more challenging times. Look at the oil sector, for example. Since the beginning of 2006, the Select Sector SPDR Energy Fund (XLE) is up about 13 percent. But check out the big pullbacks along the way, some that have lasted for weeks. Pick out a closing price in January through March on the graph below and it is likely that as you move forward in time, whether a month or four months into the future, there is another close around that same level.

Given it is advantageous for the option buyer to have directional trends, we found it to be important to create trends where there really isn't a trend. We did this via the "pair trade" approach, a strategy that we introduced to our subscribers in the beginning of 2006 via our Hedge Hunter program. A pair trade involves buying a call on a stock within a certain sector and simultaneously playing a put on another stock within the sector. Or, one could pair the call with a put on an exchange-traded fund (ETF) or index. For example, one might consider buying a call on a retail stock and pairing this trade with a put on the Retail HOLDRS Trust (RTH).

Essentially, what one does with the pair strategy is to re-allocate the typical dollars spent on a directional options trade that has the opportunity to yield sizeable profits and make it a less aggressive position. Instead of making a big directional bet with $4,000 on a call, one might consider putting up $2,000 on the call and hedging the bet by investing $2,000 on a put on a stock within that sector, or a related exchange-traded fund (ETF). The $2,000 directed toward the put can be money well spent if an unforeseen corrective move in the sector develops or if there is an unforeseen shock to the overall market. This can lead to more consistency in terms of profits and less trades that leave a big black mark on your portfolio.

The idea is for the returns on the call trade to significantly exceed the losses from the put trade in the event that the retail sector rallies, or vice versa in the event that the retail sector declines. In other words, if you like a particular stock and buy calls, you need not worry about that sector taking a major hit that causes a huge loss on your call position. In fact, such downside volatility might even result in a winning trade if the put profits are bigger on the put than the losses that stem from the call. The ultimate scenario, of course, is for both trades to work out in your favor.

Essentially, the strategy above creates trends where there really isn't a trend. Refer back to the graph of the XLE above. Clearly, the price action has been very choppy. And there has been choppiness in a stock that we follow closely in this sector, Ultra Petroleum (UPL).

Now, check out the relative-strength chart of UPL versus the XLE. Can you see a trend that is more developed than the graphs above? Clearly, there is major underperformance of UPL versus the XLE. So, in the event that we thought this underperformance trend were to continue, we would pair UPL puts with XLE calls. If this scenario were to play out as expected, we would expect to make money on the trade, whether the energy group rallied or declined, which it has been prone to do throughout 2006. For example, if energy stocks would go through a decline, we would expect that UPL puts would turn out bigger profits than the losses from the XLE call, since we'd expect UPL's decline to be more severe than that of the XLE. And if energy rallied, we would expect the XLE calls to give us bigger profits than the losses from the UPL put, as the XLE has outperformed UPL in the past.

In a paired option trade, a trader initiates a trade by buying a call on a stock he likes within a sector, while simultaneously buying a put on another stock within that sector (or buying a put on an ETF). Or, one might buy a put on a stock within a sector he does not like and hedge this trade by buying a call on another stock or ETF within that group. While the position consists of being long a call and long a put on separate underlying assets, it is typically managed as if it is one trade. The idea is to try to put approximately equal dollars in the call and the put. So, if the call is up 100 percent and the put is down 60 percent, the position is net positive by 20 percent ((100-60)/2 = 20).

The appeal of the strategy is that it can improve your option buying win rate by making you less vulnerable to unexpected sector moves. And since you have a hedge in place, the average loss tends to be smaller relative to simply buying a call or put in a directional type trade. The fact that your win rate improves and your average loss declines allows you to book smaller wins.

So, how can you improve your win rate? Think of this. You buy a call on a stock that you think will rally strongly. At the same time, you think the sector and/or market could take a hit and thus hedge the position by buying a put on the market or a sector index. With options, remember, you can only lose the dollars you invested, while your potential profits are unlimited. So, in this example, the put that acts as a hedge provides unlimited profit opportunity, and the most you can lose on the call is the premium you paid. In the event that the sector or market experiences a major decline and takes the stock down with it, the call you are holding is underwater, possibly at steep losses. But, your put option may more than double, allowing you to net a profit on the trade.

Yes, in pair trading, the absolute worst scenario can and will happen. That is, both your call and put move against you in a big way. While this is rare, note that the other possibility is that both positions can move in your favor.

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