Covered calls & puts combined with pair trading

Discussion in 'Options' started by BarryL, Sep 25, 2009.

  1. BarryL


    I have lurking on Elite for a few years but seldom post , and have a question for some of the more experienced members , I have been looking into doing some pair trading in my swing acc, and like the idea of being hedged , I also did a few years of covered call writing , What are the pros and cons of combining the two methods . IE pick whatever pair you plan to put on then writing an , at or just out of the money call against the long side and writing an out of the money put against the short side . so you could collect the premium and gain some time decay as the pair come together , I can see that you are not market neutral the same way as regular pair trading and it is not always the long side that gains and the short side that falls for the spread to close both can can go up or down with the market just by diffrent amounts, Barry
  2. spindr0


    I think it's a bad idea unless you consistently identify pairs that never move on out big time and stay within inside the strike you're writing.

    Pairs trading is geared toward a pair that has sector correlation but not a direct price correlation. IOW, if the sector/market goes up, both will go up but hopefully the spread difference will shrink as reversion occurs and vice versa if both head down (oversold gains more than overbot loses and vice versa)..

    If you cap one side of both positions with covered writes, that means that the capped side will no longer offset a big move in the other leg of the pair, assuming that you're doing a good job in your pair selection.

    IOW, suppose ABC is long at 50 and XYZ is short at 60 and you sell the 5 pts OTM options (ABC 55c and XYZ 55p) and both move up 10 pts. On the stock side, you lose 10 on ABC and only make 5 on XYZ.

    I'd sooner explore the possibility of buying the OTM protective options so that you're truly hedged against big adverse moves.
  3. BarryL


    Thanks for your quick reply , I see that now it only would work in the few cases that the market remained flat , any big move in both in either direction you could a lot more than you stood to gain by the spread closing Barry
  4. spindr0


    You're welcome.

    In addition to exploring the long option hedging, I'd tke a look at the concept of finding several attractive candidates in the same group (under and over vlued).

    Suppose you execute the aforementioned pair of long ABC at 50 and short XYZ at 60. Let's assume that a market/sector event really moves them but they move in tandem (spread doesn't widen or narrow). For example, they both move up 5 pts. One has a nice profit and the other has an equivalent loss. Book the 5 pt gain on the long side and replace it with a pair equivalent amount of long undervalued shares of NOP. No net gain yet but reversal may be beneficial as well as an eventual spread contraction. Booking gains is never a bad idea. It's the accruing losses that are the problem :D

    An alternative idea that I haven't explored in depth would be to book the ABC profit and then hedge the short XYZ shares with long XYZ calls... or perhaps long ABC calls (restoring a pseudo pair). It might be viable... or not.
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  6. gkishot


    You can't judge by just one outcome whether a strategy is profitable or not. My guess is that the strategy is profitable over long time even if the spread between pairs won't change.
  7. spindr0


    On the surface, that seems reasonable. But if you look deeper, there are complications.

    The moment you turn the pair into a CC/CP, you mutate into disparate net deltas per side. IOW, the supposed good side's delta will be less than 1.0 but the other side will remain near 1.0

    In more practical terms, ABC is long at 50 and as it rises, the delta of the 55c keeps increasing, diminishing your gain. The higher it goes, the less you make, incrementally until you get near the cap at which point its pair hedging ability will be crap. XYZ short at 60 loses $ for dollar as it rises. With a diminishing delta, the XYZ 55p offers minimal and as well as less and less offsetting gain with each point of rise. It will provide peanuts.

    Net net, if the pair rises or falls by the same (significant amount, you've imbedded a loss in either direction before even it gets to either strike. Add a little spread divergence and it's a double dose of cap and crap :)

    Yeh, there are many possibilities but it's somewhat like the risk/reward of a CC versus a vertical. You may make a bit more in one direction but you can lose a whole lot more in the other direction. If you want to chase pennies and risk dollars, so be it. Nothing wrong with that if it's in your comfort zone. It's all personal choice.
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  9. Jesus


    Yeah I agree with Spindr0, you do not want to do covered calls and covered puts as a pairs trade a whole lot. Caps your upside while leaving downside unlimited. Could be disastrous if market moves BIG. I suppose you could maybe do a credit collar and position your long call/put more OTM to collect a little more cash. But thats only in a sideways market. Risk/reward just isn't great in any of any of those trades though.