Options 101: Pairs Trading

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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.

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 The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

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