Pairs Trading?

Not only is this statement an inexactitude, but a falsehood too.

The maximum risk in a ratio spread is when the underlying expires at the short strike. In the case of calls, those so called multi level buyouts will yield you a huge profit. On the flipside, if the stock goes to 0 you only lose the premium paid for the spread(as you know the spread can also be done for a credit, so you can even make a little $$).

On the flipside, trading pairs can wipe out even the most capitalized traders as there is no guarantee they will converge.

Didn't you used to be on the floor of the CBOE or something?

 

Well, let's review....(yes, my brother and I spent a decade or more on various options floors, primarily the CBOE and PSE).

Please re-read your comment above. In reality the Maximum PROFIT on a ratio spread is when the stock closes at the short call strike price, not maximum risk.

(Bear with me, and possible decimal points, LOL)
Long 10 30's, short 40 40s. You're "in" at $32.00 stock price.

Stock goes to $50..

You make 10 x 18 = $18000. Assuming no premium paid on calls.

You lose 40 x 10 = ($40,000) (add back your premium received on calls, perhaps 40 x .50 or so $2000. Net -$22,000.

Now, buyout at $70.

Just add to above.

Plus 10 x $20 = + $20,000.

Minus 40 x $20 = ($80,000). Now you're down $82,000 total.

(detail of exact premium or commissions not withstanding, and this is, of course and "extreme" example just to make it easy)

Another scenario: Buy 10 $30's for $32,000 (assuming $2.00 calls), sell 40 $40's for $.50, collect $8,000. Stock goes to zero. You lose $32,000, you keep the $8,000, thus $24,000 loss.

I've seen much more risky "spreads" put on near expiration, and I'm certainly not advocating this strategy, but many use it.

I don't mind 'inexactitude's" - but I don't like "falsehoods" - we all make mistakes, but I think we can discuss rather than accuse, it's much more gentlemanly.

(Am I missing something?)
Don

 

Don, I believe the poster got his terminology mixed up. I think he was referring to a backspread, not a ratio spread. Not sure what all this has to do with pair trading.

Don, do you agree or disagree with my analogy that pair trading has the same p&l profile of a naked put seller?

 

"Backspreads were very goooood to us" - back in the day, LOL.

The gentleman came on a little strong, dontcha think?.. geez ....I gotta get this bullseye off my back, LOL.

Not sure about a p&l "profile" - I will pass that question along to PairCo for review (ya gotta know when to pass the ball).

I feel that selling naked puts is the same risk-reward as doing a covered write, how eo you feel about that? Less commissions, less carrying costs obviously.

What kind of options strategies are you finding to work with a good profit profile, I would be interested to know (don't give away too many secrets, just in general). As things change, who knows, I may find myself back on the exchange again (probably too old to keep up with you young guys, LOL).

Don

 

:eek: oops, sorry Don I did mean a backspread. I did come on a bit strong there.

I guess my point was that ratio spreading and pairs trading as you alluded to are 2 very different vehicles. But sure, any time you are short more options than you are long, the risk is significant up to unlimited. Which isn't unlike pairs, imo.

 

Don as much as I respect you I would strongly disagree with this statement BUT only on the basis of the individual traders portfolio size.

I think that this is a VERY important factor in this case!

Personally Vertical Spreads are my road to riches and even though I've toyed with Equity Spreads as ARB trades I still believe that (when done right) 6-8% monthly returns on Vertical Spreads are very doable (currently averaging 3-5%)

 

Regarding naked puts and pairs, with deference to PairCo.

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Could be similar. Both are income producing strategies. Similar to pairs in that if/when something goes bad it could wipe out some previous earnings. But, pair trading has many faces, and over 12 distinct strategies are possible to engage in. Perhaps the analogy is a bit too much of an umbrella comparison, but in some cases could prove to be accurate. Since we have been spreading out our overall risk via additional pairs and smaller share size increments, my feeling is that the chance for “ruin” (via “element of ruin”) is small.

Element of Ruin – The likelihood that a player or a team of players will lose their bankroll. Usually expressed in percent form. In 1981 Ken Uston wrote that his blackjack teams used a 5% element of ruin, which meant that his team’s bets were calibrated to yield a 19-out-of-20 chance of doubling a bank roll, and 1 in 20 chance of going broke.

I know that blackjack is much more finite of a game, and I’m just using the comparison as a “way of thinking about trading” – not an absolute.

(and, yes, that is 2 standard deviations, of course).

Don (with help, and I usually could use some, LOL).

 

Regarding, from Mav "Don as much as I respect you I would strongly disagree with this statement BUT only on the basis of the individual traders portfolio size."

That is covered writes vs. naked puts, risk reward ratio.

My math tells me this:

Buy stock at $50. Sell $50 call for $2.00.

Stock goes to $100. You make $50, Lose $48. Net $2.00
Stock goes to zero. You lose $50, make $2.00 = Lose $48.00

Sell 50 strike put for $2.00 ($4.00 straddle price).

Stock goes to $100. You make $2.00.
Stock goes to zero: You have stock put to you at $50. Lose $48.

Again, am I missing something, or is my Alzheimer's kicking in? I'm just trying to do the math, but my poor brain is getting tired.

More commissions on stock transactions vs. naked put sale (but in one scenario you may have to pay to put the stock).

Sell the put, you're not out any cash, no interest, and you may collect interest on the money. Thus the difference in puts and calls at times.

??????

Don (brain getting tired now, LOL).

 

Don that was me (Exodus) not Mav.

Although I agree with your math theoretically it never plays out like that in the real world and each trader will have a different loss depending on their tolerance level and portfolio size.

This was my point, as silly and obvious as it sounds.



Back to Pairs Trading (arbs) ... can you give me an ideal of what kind of monthly returns your GOOD traders are averaging please?

Thanks

 

Yes Don, a naked put is the same thing as a covered call.

Pair trading and naked put selling have the same risk structure because both involve unlimted risk on the downside and offer limited upside. With both strategies you can spread out your risk by either doing many different pairs or in the case of selling naked puts, by doing that over several tickers. If you pick any trader at random at Bright or Pairco or whatever and graph their equity curve, you will notice that it will be indentical to that of a trader who sells naked puts over a portfolio of tickers.

I guess you and Bob never thought you were in the naked put selling business.