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 (
) 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. (
) 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 (
), 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
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Wealth-Building Techniques Using Equity & Index Options