pair trading stocks -> options

Discussion in 'Strategy Development' started by sheepsucker, Aug 29, 2012.

  1. Hi,

    One of my pair-trading strategies has proven quite successful and I would like to increase leverage.

    Can I just start trading options on the stocks I get signals for in order to increase the leverage? There probably are some things I need to take into account.
     
  2. H2O

    H2O

    Pair trading using options requires a good understanding of how options move relative to the underlying and what causes options to move in general (delta, rho, vega). I suggest you educate yourself on this first and also use that time to paper trade so you get some understanding of option execution specifics (liquidity / bid-offer spreads etc.) although nothing can compare to live trading.

    I'm not saying it cannot be done - there is certainly room for options in a pair trading environment, but it is not as straight forward as you suggest in your initial post.

    Alternatively you could consider joining a firm which will provide you with extra capital so you can trade more size in the underlying. (I have no affiliation, but Bright - through Pairco - should be able to help you - just like many other firms btw.)

    Hope this helps
     
  3. Thank you H20!

    Will look into your tips.
     
  4. sle

    sle

    You want to do it in short-dated options - this would avoid Vega risk. The beauty of trading pairs using options is mostly in the fact that you can take into account the directionality of the move. For example, if you think that in a rally stock A will outperform stock B, you can buy calls on A and finance by selling calls on B. This sort of thinking, combined with simple break-even calculations and some basic thoughts on convexity in the pair would get you far enough.
     
  5. you are taking a HUGE risk doing that as you are naked on B - what happens if B is bought out at a 50% premium?
     
  6. H2O

    H2O

    That is always a risk, but the same applies if you're trading the underlying... (and there's also the same chance that A is bought out, in which case you would benefit)

    OP was asking about pairs trading with options, I assume an understanding of the risks of pairs trading.. Sle just showed 1 way to use options from a pairs trader's point of view.
     
  7. sle

    sle

    You should avoid any takeout names to begin with, irregardless if you are trading options or delta-1. If you really feel paranoid, you can instead do it in spreads (e.g. call spreads or put spreads).
     
  8. heres a tip :

    beta correlations only work out on the long run aka 6 month options

    if you use front month options you'll blow yourself up , do a backtest


    you can thank me later
     
  9. sle

    sle

    First of all, what do you mean by "beta correlations"? There is beta and there is correlation, two separate things. Second of all, beta works on shorter times scales and you can (and I do) make money using short-dated options in single stocks (not necessarily pair trading, though).
     
  10. Not entirely separate, as correlation is a component of Beta. Beta is covar(a,b)/var(b). Covar(a,b) is cor(a,b)*sigma(a)*sigma(b). So Beta can be written as cor(a,b) *(sigma(a)/sigma(b). IOW, Beta is correlation scaled by the ratio of vols.

    He was, in his post, as far as I can tell, referring to the correlation component of Beta.
     
    #10     Aug 31, 2012