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
he stands to lose, should AAA and BBB both defy his predictions by
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
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Wealth-Building Techniques Using Equity & Index Options