Options Strategy of the Day: Pair Up Your Options; There's Safety in Numbers

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Violent and volatile market conditions, like those we have experienced during the past several weeks, can be quite intimidating for your average trader. Furthermore, the sheer scope of the recent plunge in the broader market -- the Dow Jones Industrial Average ( DJIA ) peaked at 11,258 on April 28, less than a month from today's low at 9,774.5 -- is enough to shake the confidence of even the most hardened options trader. However, there are steps that you can take to manage your risk and protect profits, regardless of your overall bias toward the market. One such strategy that can be employed by either bulls or bears is pairs trading.

The basics of pairs trading are fairly simple; you purchase two separate-yet-related options, usually one put and one call, and manage them as if they were a single position. What's more, this strategy can be employed effectively even in today's whipsaw market conditions. But perhaps the biggest draw of pairs trading with options, as opposed to stocks, is that you can improve your win rate while committing significantly less capital to the market due to the leverage provided by options.

Constructing a Pairs Trade Position


For a better understanding of the concept, let's take a look at an example. Let's assume that you are a market optimist, and believe that the current weakness on Wall Street is merely a correction in the overall bull market. However, since you are wise to the ways of the market, you know that it is a good idea to hedge your bets, especially with the DJIA unable to hold firmly above the 10,000 level. Via your research, you've discovered that technology firm Imaginary Chip Manufacturing Corp. ( ICM ) stands a really good chance of being the next hot stock on Wall Street. However, the technology sector, as represented by the tech-heavy PowerShares QQQ Trust ( QQQQ ), has been on the ropes lately due to economic concerns in Europe. You want to bet bullishly on ICM, but concerns about the overall market and the tech sector have made you unwilling to act.

Enter the pairs trade. By purchasing an ICM call and simultaneously buying a QQQQ put, you can capitalize on your expectations, while simultaneously hedging against weakness in the broader market. In the best case scenario, the QQQQ will continue to suffer, and ICM will enter a stellar uptrend.

However, it is possible that one leg of the trade will not play out quite as expected -- ICM shares may follow the rest of the market lower, or QQQQ may reverse course. In any event, you must consider the pairs trade as a single entity before cutting losses or taking profits. If your ICM call is at a 75% gain and your corresponding QQQQ put is at a 30% loss, remember that your pairs trade, as a whole, is still on positive ground. Calculate your return on the entire position before taking action to close out your call or put.

Because the two trades act as natural hedges for each other, the upside of pairs trading is that you could enjoy a greater win rate than you would by simply playing straightforward, un-paired directional trades. By extension, though, your "wins" will generally be smaller. The other caveat to pairs trading is that you are effectively "double long" on option premium. As such, your position is considerably more vulnerable to time decay, meaning that if the underlying securities remain stagnant, your pair trade will suffer losses due to decaying options premiums.

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.

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


This article appears in: Investing , Options

Referenced Stocks: DJIA , ICM , QQQ

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