option strategy for a stock pair with negative correlation?

Discussion in 'Options' started by elitetradesman, Oct 14, 2011.

  1. Suppose you have stock X and Y that have a negative correlation so that when X rises, Y drops and vice-versa. Moreover, the net percentage move between them is less than 2% within a given period of time. For example, if X drops 4%, Y will rise no more than 6%. If X rises 5%, Y will drop at least 3%. It's impossible to know ahead of time which of X and Y will rise.

    Is there any option strategy that can leverage this fact? Shorting both X and Y would not be profitable because the net percentage is very often positive.

  2. Assuming vol in X - Y is positive.

    Sell calls in X and buy puts in Y.
  3. Before you can determine if there an option strategy to profit from this you have to determine if there's an UL pairs strategy that works.

    Forget the "negative" part of the correlation for a moment because that's just a question of direction (long or short).

    A good situation for a standard pairs trading strategy (one long, one short) is one where the sum of daily changes (the pair difference) swings back and forth in some range of regularity. You're objective is to trade the spread (expansion or contraction).

    For example, take the ideal sine wave. At the peaks, the spread is the widest and that is where or near where you take your position, shorting the overvalued and buying the undervalued. Under/over value may be the wrong word usage. Perhaps extreme value would be more appropriate.

    There's no guarantee that when you take a position at what you think is a peak that it will be a peak. The spread difference may widen more and if your concept has legs and you believe in it, you add more. There are times when you just have to carry a position.

    Most likely, this spread also jiggles around intraday and if so, that presents an opportunity to shift your intraday bias, adding more to one side or vice versa, getting back to whatever you deem flat to be by EOD. This involves having some idea of what moves the UL's - for ex, interest rates, oil or gold prices, good/bad day for a sector, etc.

    If there are any other equities that are correlated similarly, you can take winners off the table and substitute them but that's another story.

    Once you determine the tradeability of the pairs, then you can look at option scenarios. I will confess that I've done the above with UL's but have not found a reliable way to do so with options.
  4. Thanks, I've done a quick backtest, but it appears that its profit/loss distribution isn't any more different than conventional strategies(vertical spread, butterfly, etc) using just one of the stocks. Maybe it's because of option premiums?
  5. Look at the difference between the volty of the straddles of X, and Y. If it is higher than your number (2%?) sell straddle that has higher volty, long the other straddle, and hedge with the pair.
  6. Work on the design of filters might be useful. There are a couple of authors who did some good work as it relates to trading.
  7. No, you wouldn't want to trade a position that is bimodal on delta.
  8. OP: did you have a chance to test the above?
  9. You don't want to do that. Bimodal deltas can easily result in getting pinned on your long vol combo and trade deep intrinsic on a leg of the short straddle. Bad, bad idea. It's why pros don't trade straddles in dispersion books. If it's a bad idea for dispersion it's terrible in a 2-way.
  10. Would you mind expanding on that a bit? Assuming one was trading a typical dispersion basket with positively correlated components, how is doing say ATM component puts vs ATM Index puts different than ATM component straddles vs. ATM Index straddles? Risk of pinning on the longs and being deep ITM on the short is still there, no? Good chance I'm missing the point entirely here - but curious b/c I run a (really filthy) dirty dispersion strat with synthetic component straddles vs. naturals in the index.
    #10     Oct 19, 2011