Trader Q&A: 3 Advantages of Pairs Trading

Pairs trading is a limited-risk way to play stocks in a potentially volatile sector

Aug 10, 2016 at 2:46 PM
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Options trading can be an intimidating undertaking, but if you play your cards right, these vehicles can offer leverage that "vanilla" stock buying or short selling can't. In fact, there's a way to play stocks in a potentially volatile sector that involves limited risk and more than one way to profit: pairs trading

While pairs trading is considered a "hedged trade," it's not a direct hedge in the sense that a protective put or collar are. The concept is to play a directional trading idea while simultaneously guarding against unexpected headwinds or tailwinds in the given sector, or within the market as a whole. In a pairs trade, traders purchase two separate options -- one bullish, one bearish -- on two stocks from the same sector.

Say you have a bullish outlook on stock ABC, but you're apprehensive about headwinds that are currently plaguing the sector; you could use a pairs trade to minimize your risk. Specifically, you could buy an ABC call, and simultaneously buy a put on sector peer XYZ. By playing both legs of the trade as a single entity, it's possible to make money -- or at least minimize losses -- even if one of the legs finishes out of the money. 
To further explain, I sat down for a Q&A with Schaeffer's Senior Equity Analyst Joe Bell, CMT, who elaborated on some of the nuances of pairs trading.

When is a pairs trade appropriate, versus a different hedging strategy?

JB: A pairs trade is appropriate when you believe that one stock is going to outperform or underperform another stock within a given time frame. The use of two stocks within the same sector also offers the opportunity to be hedged by a major move in the underlying sector that may affect both equities.

When is it best to pair a stock position with an ETF?
JB: We rarely pair a stock with an ETF, but it can be successful when you have identified a stock that you believe will outperform or underperform its industry or sector. 

What are the advantages of pairs trading?

JB: The advantage of pairs trading is that you have three major ways of winning on the trade: 

  1. You may have the call and put position become profitable and win on both legs of the trade.
  2. The stock that you have a call on could outperform the stock you have a put on, and the relative outperformance could lead to the overall profitability of the pairs trade. 
  3. The last scenario really highlights the benefits of using options and the leverage they bring to the table. Even if you are dead wrong on the losing side of the trade, the most you can lose is 100% of the premium paid. With options, you have the ability to gain more than 100% on the winning side. So, if the entire sector makes a huge move in one direction, you may lose 100% on your losing side and gain well over 100% on the winning side. The leverage of these options presents this great opportunity.

What are the disadvantages of pairs trading, and when should traders avoid this strategy?

JB: A key disadvantage is that you are opening two trades at the same time, so generally premiums will be higher than simply buying a directional call or put without a pair. In addition, this trade relies on volatility and a directional move by one or both of the underlying stocks. If volatility suppresses or both stocks trade sideways, you could lose on both legs as time premium decays and both the call and put are sitting at losses.

Is there a rule of thumb for how much capital to invest?

JB: This really comes down to how much capital you have available for trading, and your ability to take risks. This also depends on each individual’s goals, risk appetite, constraints, and liquidity needs. We generally state that you should never allocate more than 10% of your available trading capital for this strategy to any one trade. You will have winning and losing trades, and you want to be able to withstand the ebbs and flows of the market so that you are still in the game over the long term. Betting too much in one trade can lead to a big win, but over the long term the profitability of losing all your trading capital is too high to make it a successful long-term strategy.

At what point would you partially or fully exit a pairs trade?

JB: This always comes down to the individual trade and the individual trader. The key with loss and profit management is to have a consistent plan in place and adhere to this plan. Different methods will work with different traders and much of this can depend on the individual’s personality and trading psychology. In general, I like to take some profits off the table if the delta on each option is no longer close to the other option’s delta. By aligning deltas, I can make sure the trade no longer becomes a simple bet on one stock. 

With that being said, there are times where I feel strongly about one side after the trade has been put on and will let that profitable side run. Managing these trades also comes down to outlook and analysis, which is a similar process that I go through when entering the trade. If my outlook for one or both stocks has changed, perhaps I need to shut it down. The major rule should be setting targets and levels when you enter the trade that you adhere to once the trade has been opened, though.

Do you have any recent examples of successful pairs trades?
JB: In our Hedge Hunter service, which focuses solely on pairs trades, we recently closed out winning pairs trades on Stryker Corporation (NYSE:SYK)/Cepheid (NASDAQ:CPHD) and Baxter International Inc (NYSE:BAX)/ Hologic, Inc. (NASDAQ:HOLX) for gains of +64% and +52%, respectively.


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