You can use options for pairs trading, but it is best to use in the money options with a delta of 80 or higher. This greatly reduces the theta decay. Vega is a wild card that may go either way. It might be best not to use options in times of very high implied volatility. IV has recently declined to lower levels. The options are used as a proxy for the underlying stocks. This reduces the risk, because the largest amount that can be lost is the amount paid for the options. The options should be adjusted so that the combination is beta neutral. Use only options with greater than 40 or 50 day to expiration so as to reduce theta decay. And of course the pair should have a correlation of 80 or greater.
Very interesting... I'll have to look into this method. I've just come across a very cool options analysis program that I think will be very helpful with this.. Thanks.
A lot of firms used to do pairs trading with options before the whole dispersion model took hold. Firms looked at pairs trading in terms of IV as opposed to delta. Calls and puts are thus a moot point since they are then essentially the same thing and you can keep your vega in line a lot easier then trying to rehedge delta to keep that ratio constant. Also you can show some patience with positions and not have to cross a lot of markets and jeez maybe even take some edge out of the market depending on orderflow. This is also the very beginning basis for dispersion trading
Spin, come on man before there was dispersion trading there was pairs trading in IV. Pairs trading in IV is essentially a rudimentary form of dispersion. Rather than trading the IV on options in an index vs. options on the index you traded the IV of two stocks in a sector vs. each other.
Sorry X-man, I got sidetracked by your previous post. I didn't register that you were talking about IV offsets (even tho it was right there in black and white) whereas I am interested in/was thinking iof price movement in conventional pairs trading.
I've done a few pair trades using DITM options with some success. I use DITM options as they seem to be a good substitute for long/short stock if IV is not too high and liquidity is good. The main reason I use options is to enable pairs trading in an IRA where you cannot short stock. Although I also use options for pair trading in a non-IRA account where I can pay minimum time value. Or where I am nervous that a particular leg has the potential to move big against me. It's been working pretty well so far. I had one pair that moved against me significantly and the options limited my loss. Sometimes I setup the pair using stocks and then convert to options with combo limit orders trying to get a decent fill. Often instead of exiting a DITM option order that has no TV I'll just buy/sell the stock to become neutral and exercise at expiration. This eliminates any option slippage and in the meantime I have a lottery ticket if the stock happens to move real big in the OTM direction. Don
liquidity and bid offer spreads in the deep options stink the mm's need to be able to hedge the delta with the stock so the options are always wider than the stock.