And your point is.... My statement was in response to the OP's statement that he/she has limited capital to "pair trade" stocks.
total_keops had recommended to me to look into spread betting, and he was just pointing out that it's not the same as spread trading. I'll see what the futures may bring )) but I'm not sure my broker is on the futures bandwagon. BTW, I am in a free country (US)
If you buy OTM options, the most likely result is that all options will expire worthless and 'pairs trading' will have no bearing on the trades. Mark
I have thought about this and see a major problem with option pair trading that nobody has mentioned. Say my pair model tells me to go long 1 share of A and short 1 share of B. So if I am doing it w/ options I want the deltas to be equal. Lots of ways to do this, just assume long 2 ATM calls on A and short 2 ATM calls on B for now. Then both stocks go up by a large amount but the spread stays the same. In a normal stock pair, your gain on A offsets your loss on B so nothing happens. In this option pair example you lose money when this happens. The delta of A drops and the delta of B goes up at the beginning of the move so you are not balanced. You would even lose money when the spread converges perfectly if the stocks move far enough away from the original prices. In the other strats I could think of quickly there are still scenarios where you lose money when the spread stays the same or tightens. IOW if you come up with an option strat to fix this problem then another one pops up. So do you guys see any way around this?
Your issues are limited capital and inability to obtain margin. Transaction costs are not an issue because with equities, slippage is less and at most deep discount brokers, so are the commissions. As I see it, the main problem is that if you use OTM options, you layer on more obstacles (higher commissions, more slippage, more legs, lower delta, etc).. It can work out well if as with most standard option strategies you get timing and direction right as well as a little thing like a big move in the pair. Otherwise, you're swimming upstream.
My idea would involve giving the option a chance to increase in value, then selling out of it long before expiration. If I didn't let it get too close to expiry, I wouldn't need to worry about it expiring worthless, or hopefully running into liquidity issues. All part of my noob thought processes... please correct me if I'm wrong.
I don't know what others would consider as an option "pair" but to me, selling calls on "B" would not be a substitute for the short leg of the equity pair. You would buy calls on "A" and buy puts on "B". With a large move in either direction, the winning side goes toward 1.0 delta and the losing side heads toward zero. For example, a -1/-1 pt pair (cost) could go to 0/5 or 5/0 for a net gain of +3. And in fantasy land, you then cash in your winning 5 pt leg and hold the worthless leg until the terrific/horrible news hits (before expiration) and you cash it in too
Based on the numbers I've run so far, the profits from pair trading while consistent are fairly small. When buying equities outright, the brokers I've looked at charge per transaction, regardless of the number of shares. Scottrade, for example, charges $7 per trade. If I trade one share, I pay $7/share. If I trade 1,000 shares, I pay $.007 / share. Since the profit per share seems to run in the $1 - $3 range, I can't possibly make money unless I can trade enough shares to overcome the commissions.