I'm curious if anyone is using options to execute a pairs trading (statistical arbitrage) strategy. I'm looking into pairs trading and it seems that the effective leverage available with options would be a great way to overcome the cost of transactions, especially since most brokers punish small cap traders with regressive commission schemes. Brian-
I've done a lot of pairs trading and have wondered the same. On my "to do" list is to download some historical data on a number of issues to see how well this idea holds water. I use IB and thier option comm sched is slightly higher than for equities so there's no advantage there. Another disadvantage is that option spreads tend to be wider and usually have less liquidity. I think that the potential advantage is that if both of underlyings move, the long option on the losing side will have a limited loss versus what it might have been had it been equity. Conversely, w/o that move, time decay is going to hammer both sides. I don't know how feasible all of this is and until I crunch some numbers, it's just a light bulb moment.... Or not.
Your points are well-taken, but it seems to me from looking at the charts that if one uses well OTM options, the time decay is greatly reduced, and the lower delta could be made up by buying more contracts. Brian-
I've tried in a paper trading acount and it's hard to beat the transaction fees (comish + spread + time decay). Thew best thing is that you limit the losses but you pay a price for the privilege. I did not totally discard the idea so if someone tells you that it can be done it's possible but it wasn't looking good from the start so I just put it under the stack.
Ayyyyyy don't think so. There's nothing in a chart that reduces time decay. Time decay is constant. Going OTM just means lower premium paid per contract and if you ramp up the number of contracts in order to get more delta, you're swilling more slippage and commissions, you're increasing the number of legs decaying and you're right back where you started. In order to minimize time decay, one has to either buy as little premium as possible (OTM) or sell some premium as an offset. The latter isn't feasible because spreads will cap the profit and that's not likely to make enough to offset the other side, let alone profit nicely. What intrigues me as a possibility is using long OTM options to hedge the equity pair. With a move, the 1.0 equity delta of the winning side will generate a nice profit and the OTM protective leg on the other side will limit losses. Sounds good on paper but I'm not sure how practical it is.
You then increase theta again to comparable levels, because you have more contracts You also increase contest risk (bid ask spread + commish) Just something to factor in.
The whole idea with utilizing options with pairs is to be able to limit the losses. Hopefully, the yield cededwill be much less than the principal lost when a pair blows up. The paper trading account is a good idea. I opened one up a coupla months ago ths ago but have been too busy to fiddle with it. I should toss some positions into it and let them do the tracking.
My primary reason for looking at options was as a way to create a form of leverage. As a noob with limited capital I would find it rather hard to overcome transaction costs when pair trading equities outright, and I'm not sure I'm ready (or qualified) to convert my cash account into a margin account. It seems from the comments that the costs of obtaining the virtual leverage of options would likely eat up any advantage (besides hurting my brain), but I'll keep considering it while I look at other 'options'. The one thing I feel confident in right now is the value of pair trading itself... I just need to figure out how to execute the trades with limited $$ and still make enough $$ to make it worthwhile. Thanks for all the input! Brian-
If you are living in a free country (I mean anywhere except in the US), you may be able to use "CFDs" of "Spread bets". They offer leverage of about 10-20 in exchange of a penny on the spread and maybe some financing costs. CMC Markets comes to mind. One guy in the Pairs Trading Journal use it I think for UK stocks.