Yes, one of the many strategies that LTCM used was pairs trading. As MTE mentioned, it was their extreme debt to asset leverage that was their downfall. It was something like 30:1 before the Russian bond defaults eroded their equity and forced them to unwind positions prematurely.
I have actually trades pairs and done fairly well at it. However, it was based on "deal terms" and not typical beta pairs trading. Technically it works very well for trading "deals" (take-overs, spin-offs, etc.) As far as pairs trading, I did consult for a fund to help include options using a ratio collar/fence strategy with their pairs to limit risk exposure and enhance static yields. It works well - however not all pairs work well for this scenario - based on volatility, strike dif, and liquidity.
My copy of Natenberg (copyright 1994) has a whole chapter on pairs trading options. I don't believe it is the last word on the subject, but it is a good place to start thinking about the concepts involved.
dona, yep, I actually just read the book and found the chapter. discusses in som detail exactly what I was after. does anyone know of any option software that would allow you to plot multiple symbols on 1 risk graph?
Interesting, I have never seen this thread. I have done this before and it is not that difficult. Schedule permitting I will put together a spreadsheet of the basics of this strategy and post it on my blog next week.