Pair trading in Options

Hi guys, I have a equities pairs trading strategy that isnt terrible. I would like to see how this translates to options, but Im not quite sure how to translate these positions into options. I would usually buy an equal dollar value of the underlying. In the case of options, would I buy the amount of options that would most closely translate to an equal dollar amount in the underlying assuming the positions were of equal/similar Delta value?

 

If you're buying/shorting equal amounts of stock in your pairs trading, then you'd do the same if the respective deltas were similar. But chances are you're not going to find 2 option positions with similar deltas and that may complicate things.

FWIW, I've pairs traded but I've never been able to figure out an effective way to do it with options. Options are more complex than stock and I would surmise that pairs trading with options would be the same, maybe even worse.

 

spindr0, thanks for the reply. I was thinking that may be the case, but hasnt stopped me from banging my head against a brick wall trying....

 

I tried converting pair trading into options a couple of years ago. I thought to overcome the greeks' influence by using DITM options, but then the wide B/A spread killed it.

 

there goes another idea then.......

 

As Daniel mentioned, the wide B/A spread is a problem. So is time decay and a reduced delta. The only way it makes sense is if you're spotting big moves and you leverage up the option size. It wouldn't work for me since I scalp small net moves in volume.

 

Yes the B/A on ITM options will hurt when you want to close out positions in a hurry. It can be hard enough just to enter and exit a spread when it is stocks, considering possible slippage.

I've thought about this idea before as well, and really had trouble finding an advantage to using options in conjunction with stock pair trading. You are already giving yourself a partial hedge against market risk by being long/short in the stocks.

I've thought about buying puts/calls to enhance profitability when the market moves both stocks in the same direction. It sounds good, but again it will just complicate your exits and add to already heavier commissions and slippage of using a pairs strategy.

 

As an aside, LTCM pairs-traded. Not sure if with options. They blew up. Comments?

 

LTCM blew up because they were overleveraged.

 

This is something I have been thinking about for a long time.

There are guys who trade MR in the option world via volatility. It's not exactly the same thing as pairs trading but they are trading MR.

One advantage is that you can increase your leverage via using options. Another one is that your universe of potental pairs has just grown exponentially as well.

Disadvantanges are increased fees. Plus to obtain historical information for backtesting options is not an easy task.

I have found simple robust MR models work the best. Once you go into the options space you are now making your model more complicated. I believe that if you do this then the payoff better be worth it. Because the more complicated the model the harder it is to scale it.

There are several approachs to pairs trading. Alot of people have a position sizing algorithm which is dollar neutral. Others try to be market neutral and use a volatility sizing algorithms. There are several different ways to do this.

I think in the option space you will need to use a greek to determine your position size and except a certain amount of risk from the others. This could cause several problems and it is hard to determine what strikes to choose. I would never use deep ITM options. I can understand why someone would think using a 100 Delta strike is a good idea but from an option MM approach it is a bad idea.

I think using a strategy like a butterfly, straddle, strangle, TS, etc ... would be your best bet. Something which is liquid and can be executed whole. Most option exchanges nowadays do list basic strategies so you don't have to worry about executing each leg individually and the fee for executing a strategy is less then executing the individual legs. Plus a strategy would reduce some of your risk. You could determine the strategy you want to use based on your acceptible risk. The leverage you get will also be significant.

This is an interesting topic which I would like to spend more time on but time is something I don't have enough of right now. Hopefully one day I will be able to do more research in this area.

If you do find a model that works you might be able to apply it via a MM approach to really take advantage of it.

$.02