What Are Pair Options

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Options 101: Pairs Trading

In today’s column, we’re going to dissect option pairs trading , which allows investors to profit in both up and down markets without committing a significant amount of capital.

Who should tune in? This strategy is best suited for traders who are bullishly or bearishly biased toward a certain stock, but remain nervous about industry- or market-wide shakeups. The investor is hesitant to risk precious capital by purchasing a lone call or put, and wants to hedge his or her bets.

How does it work? First, the pair trader would purchase a call on a stock with the potential to move higher. However, to protect against sector volatility or an unexpected move in the wrong direction, the investor would simultaneously buy a put on a different stock within the same sector. The trader would allocate roughly the same amount of money toward the call and put purchases, with both legs typically managed as a single trade.

What’s in it for me? The best-case scenario is for the underlying stocks to move in the respective directions predicted, placing both the call and put positions in the money. However, the pairs trader can also profit if the returns on the call trade significantly exceed the losses from the put trade, or vice versa. In addition, the investor can guarantee a profit if one of the two options more than doubles in price by expiration.

Aside from the appeal of a better night’s sleep, part of the beauty of this strategy is that traders can make money from significant moves in either direction. Furthermore, compared to a stock owner or the average option player, the pairs trader is less vulnerable to the unexpected, and the hedge helps to reduce the investor’s average loss compared to buying a lone call or put.

What do I have to lose? With most hedging strategies, the “insurance” and peace of mind don’t come free. In pairs trading, the initial premium paid for the two options is (obviously) more than what the trader would pay for buying a single call or put. But, the losses typically tend to be small, since the investor is hedging a directional view.

The worst-case scenario is for both stocks to go against the trader’s initial predictions, making the call and put worthless at expiration. However, the investor’s maximum losses are limited to the initial cash paid to purchase to two options.

Let’s look at an example

Meet Pierre, who thinks the shares of tech titan AAA will rally in the near term. However, since it’s the heart of earnings season, Pierre is worried about a near-term pullback within the sector. Because he’s usually a conservative trader, and due to his industry-wide fears, Pierre is wary of buying the shares of AAA outright, or a lone call on the stock, for that matter.

As such, he opts to initiate a pairs trade. Since he’s bullish on stock AAA – which is currently trading around $50 – he buys an at-the-money September 50 call for $2.50. To hedge this purchase, he singles out stock BBB – a recent laggard in the tech sector – to buy a put. More specifically, with the shares of BBB flirting with the $160 level, Pierre purchases an at-the-money September 160 put on the stock for $5.

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His net debit on the play is $7.50 ($2.50 + $5), representing the most he stands to lose, should AAA and BBB both defy his predictions by expiration.

At expiration.

Let’s say Pierre’s forecast for both stocks flops, with the shares of AAA falling to the $40 level, and the shares of BBB rallying to the $200 level by expiration. In this case, both the AAA call and the BBB put would expire worthless, and Pierre would be out the $7.50 paid for the two options.

On the other hand, let’s assume that both stocks backpedal into the red by expiration. The shares of AAA have fallen to the $40 level, rendering the September 50 call worthless. On the other hand, the shares of BBB have trended lower as predicted, falling to the $152 level by expiration. The BBB September 160 put would harbor an intrinsic value of $8. Minus the initial net debit of $7.50, Pierre’s pairs trade still comes out $0.50 ahead.

In other words, though his original forecast for AAA fell short, the profit from BBB’s decline overshadowed the losses from his worthless call. Had Pierre only purchased the AAA call, he would be out $2.50 by now. Had he simply purchased the stock outright when AAA was trading at $50, his portfolio would be down 20% following the decline to $40.

Finally, let’s look at the best-case scenario for Pierre: the shares of AAA skyrocket to the $55 level, and the shares of BBB decline to the $150 level by expiration. The 50-strike call would now be worth $5, while the BBB put would harbor an intrinsic value of $10. Subtracting his initial premium paid for the two options, Pierre stands to make a profit of $7.50 on the trade ([$5 + $10] – $7.50). In other words, he’s doubled his money since implementing the strategy – and all while sleeping soundly at night.

Schaeffer’s Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

OAP 104: How To Use Pairs Trading With Options To Create Smooth Portfolio Growth

September 15, 2020

On today’s newest podcast I want to turn the conversation a bit and focus on pairs trading with options. And this isn’t the traditional pairs trading that you might have heard about before where you short one stock and buy another related stock to profit from any trending differences or divergences in the underlying price. Instead, I want to talk about how you can use some very basic portfolio and stock beta concepts to make smarter, more efficient decisions about which securities you use for options trading. Moreover, I want to give you the knowledge to feel comfortable taking directional trades so long as you know how to create “paired trades” that still give you an overall neutral stance relative to some benchmark index. This show is a little more advanced but I think you’ll find it helpful.

Key Points from Today’s Show:

  • Pairs trading with options to create smoother portfolio growth, smoother returns, and reduce the volatility in your account.
  • Portfolio beta weighting has to be the foundation of what you do with your trading.
  • If you understand where your portfolio sits at any point in time, then it is very easy to go out and find new positions.
  • When it comes to trading, you should know what you’re looking for so that you are more targeted and focused.
  • Be cognizant of what you are actually adding to your portfolio.

Example: If your portfolio is too bearish, then you need to focus on finding more complimentary bullish positions.

Portfolio Beta Weighting

Adding Bullish Positions:

  • If you need more bullish positions, search for trades/ETFs/stocks that are highly correlated with the market.
  • Can use beta weighting to determine how correlated the security is with the market.
  • For bullish positions, focus on securities with a beta of 1 or more.
  • A stock with a beta of 1, tracks the S&P 500. A stock with a beta of -1, will track the opposite of S&P 500.

Example 1: SMH has a beta of 1.16. If the market moves up 1 point, the SMH would move up 1 point plus. So it would move up even more than the market. If you need a bullish position, you might go after something like SMH because SMH has a positive correlation with the market and is going to move a little bit ahead of the market if the market’s rallying, which helps correct your portfolio much quicker.

Example 2: TLT, a major bond ETF, has a beta of -0.26. A -1 would suggest that TLT moves the total inverse of the market. Since it is only -0.26, if the market moves up 1 point, TLT might move down a quarter of a point. So if you want to get bullish exposure in your overall portfolio, you can’t just buy TLT because buying TLT actually gives you exposure to the market going down. If the market goes down, TLT goes up. Might have to sell four times as many positions in TLT to get the same impact as one bullish position in SMH.

*If you are trying to get a bullish position on your portfolio, TLT would require almost four times as many contracts to get the same impact as SMH

Example 3: SLV is a silver ETF. Silver has a beta of 0.06, almost a zero correlation with the market. So adding silver to your portfolio while adding another bullish position really does not help balance out what you have. Not a complimentary trade to your portfolio.

Adding Bearish Positions:

  • Buy long TLT because TLT has a negative correlation to the portfolio.
  • Even though you are adding a bullish position, because of its correlation to the market you are adding some exposure incase the market goes down.
  • If the market goes down, TLT should go up based on it’s correlation/beta.

Insight

“With $160 billion under management, if you have 15 uncorrelated return streams you can reduce your risk by as much as 80%.”

  • In your portfolio, try to have as many weak or loose correlations to the market as humanly possible.
  • Month-to-month correlations change over time.

Pairs Trade

  • FXE and SLV are two weak correlations right now that can be traded at the same time.
  • Do not have to be cognizant of trading them in any one direction; bullish or bearish.
  • Can easily add these to your portfolio and not have any skew happen in your portfolio.
  • If you add anything with a strong correlation, you have to add another trade to compensate for its impact.

Example: XOP is an oil and gas ETF with a beta of 1.51. When the market moves higher, XOP should move just as high and then even 50% more, potentially. If the market goes a point higher, XOP should move 1.5 points higher. If you add a long position in SMH, which now you’re adding 1.16 additional betas to your portfolio, you could also take a short position in XOP and neutralize that impact by a large margin. Now it’s not going to be 1-to-1, but it will give a neutral impact overall on your portfolio.

Conclusion

  • In today’s world there are very few ETFs that have a perfect positive correlation or perfect negative correlation, or a perfect no-correlation.
  • Therefore it is going to be much more of an art form than exact science for your portfolio.
  • Overall, you have to be really efficient with how you use your capital and how you correlate and beta weight your portfolio.
  • It all gets back down to beta weighting and figuring out what you need in your portfolio, and then finding the most efficient piece to add in.

[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We’ve made it incredibly easy for you to save time by giving you instant access to the complete digital version of today’s show. Click Here to Download Your FREE Copy

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Rene

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week’s question comes from Rene who asks:

Can you make a demonstration using the watchlist to find trades?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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