As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running a weekly post about options education. This week, we are exploring the ins and outs of pairs trading.
Pairs trading, as indicated by the name, is the combination of two separate, yet related options plays, on two different securities in the same sector. One play is bullish (established by buying calls) and the other is bearish (established by buying long puts), providing investors a way to play a directional trading idea while also protecting against unexpected headwinds from a particular sector, or the market as a whole.
When it comes to practicing pairs trading, there are several ways to profit. For one, both the bullish and bearish positions could become profitable, allowing winning on every side of the trade. In the second scenario, the bullish stock outperforms the bearish stock, and the relative outperformance leads to overall profitability. And third, even if these investors are wrong about the losing side of the trade, the most they would lose is 100% of the original premium paid. Still, they have unlimited potential for gains on the winning side. In other words, if the whole segment moves in a direction, they could lose the premium and still profit well beyond it on the other side.
There are also disadvantages to this type of trading. For instance, investors are opening two trades at the same time, meaning premiums are higher than just buying a directional call or put. Pairs trading also relies on volatility and a directional move by one or both of the underlying stocks. If volatility suppresses, or both stocks trade sideways, you could lose on both legs as the time premium decays, and both the call and put are sitting at losses.
When it comes to pairs trading, there are best practices you can implement to be successful. Nonetheless, these distinctions are valuable when trying to decide on how to invest in an equity.
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