If you have a pairs trading strategy and you hold positions for 4 to 5 hours... is it better to trade the equity or is it better to trade the underlying option with the most activity? also, how do option commissions in terms of bang for your buck size up compared to stock comissions
If you are a good pairs trader able to capture $1 moves in pairs then it would be ok to use options and even hold them overnight for better drift away from your entry price. Anything smaller than $1 in underlying would make options not as optimal. the spread alone save for the options which have penny increments would make it an uphill battle. To replicate 100 shares alone would probably take 2-5 options naked or 10 options as a spread (ex a vertical ) so you could conceviably end up paying $5/100 shares in trying to replicate price movement of 100 sh .
I would think the spreads on options would make them more difficult for pairs trading. Also there are more factors to consider than if you are doing some kind of statarb on stock prices - like how changes in the greeks effect prices. An example trade might help us make a closer examination.