Best Practices for Pairs Trading

A trader Q&A on the best way for options traders to establish a pairs trade

by Patrick Martin

Published on May 25, 2017 at 2:19 PM

Pairs trading, as the name suggests, pairs two separate option plays on two different underlying securities in the same sector. One option play is bullish, established by buying calls, and the other bearish, via long puts. Pairs trading offers limited risk and multiple ways to profit, and can provide an indirect way to hedge a directional play or guard against a sector's unexpected head- or tailwinds. Below, Schaeffer's Senior Equity Analyst Joe Bell, CMT, explains the advantages and disadvantages of this options strategy, and tips for establishing a winning pairs trade.

What are the benefits and setbacks of pairs trading?

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

  1. You can 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. 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.

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 the time premium decays and both the call and put are sitting at losses. 

What makes pairs trading unique from 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.

What are some best practices when it comes to pairs trading?

JB:  Once you have identified two stocks, we like to pair them by utilizing call and put options that have similar deltas. It is also important to manage the options, and you may have to re-align the delta of the position so that it doesn’t become a purely directional trade during the life of the options. We also like to play 3-6 month options or slightly longer-dated options, because these type of relative-strength bets tend to take a little longer to play out, especially considering that you are paying for time premium on two options.

What indicators/data do you look for in a pairs trade?

JB: You can utilize the same indicators and tools that you would use for directional option buying. At Schaeffer’s, we utilize our Expectational Analysis methodology, which combines fundamental, technical, and sentiment analysis to look for stocks that we think can buck the trend of expectations.

To identify stocks that will outperform, we look for securities that have a strong technical outlook, strong and/or improving fundamentals, and are surrounded by pessimism. We target underperforming equities by looking for stocks that have lagged their peers, have a poor technical and fundamental outlook, yet remain in the favor of Wall Street analysts and the broader investment community.

Are their certain sectors that are more ripe for pairs trading?

JB: Any sector can potentially be ripe for pairs trading. The key is to identify stocks that have some correlation to each other and are in the same industry or sector, so that if the broader sector makes a large directional move, you will get exposure to it regardless of direction. 

What do you see in the next few months that might be a good fit for pairs trading?

JB:  On one hand, we are entering the summer months, which historically haven’t been quite as volatile as other times of the year. On the other hand, option premiums are at some of their lowest levels in years. These low premiums make it much more affordable when you are purchasing two options on two different stocks. This can really help boost leverage if we experience volatility in excess of what is currently being priced in.

Can you think of any recent examples of a successful pairs trade?

JB: In our Hedge Hunter service, which focuses solely on pairs trades, we recently closed out winning pairs trades on Corning (GLW)/Palo Alto Networks (PANW) and Adobe (ADBE)/Cerner (CERN), for gains of 66% and 51%, respectively.


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