Using options for a pairs trade

Discussion in 'Options' started by AAAintheBeltway, Mar 1, 2004.

  1. I was shopping this past week and had the occasion to go to Home Depot and Lowe's, whcih happened to be basically across the street from each other. The contrast was startling. HD was dark, grim looking, kind of like KMart. Inventory seemed to lying around in disorder, no help around. When I went to checkout, I saw they had eliminated most of the human cashiers in favor of self-checkout aisles. Customers seemed confused, one of the checkouts didn't seem to be working properly as I saw a woman stuck there for 5 minutes. A bored customer service employee was lounging at his stand and didn't seem inclined to want to help her. The one human cashier had a lengthy line. I abandoned my cart and went to Lowe's.

    The difference was immediately apparent. The parking lot was full on a weekday afternoon. The store was bright and bustling, the employees seemed energetic. No self-checkout aisles. Very different shopping experience.

    Based on this admittedly unscientific experience, I'd like to put on a pairs trade, long LOW, short HD, but using options. Both report in May. My first thought was to put on bull and bear spreads, roughly delta neutral. HD has May and Aug expirations, but I think the May's expire before they report. LOW has Jul and Oct.

    Any suggestions for structuring this trade?
  2. I think you've got the vertical worked-out already, provided you're trading the front month(serial) options. I like trading pairs by buying the call on the long stock, selling a call on the short pair, as in the "SO" spread that's traded in the index option markets.

    As I suspected, the volty in HD is 300-400basis lower than LOW, which stands to reason due to market cap. That being said, I'd rather be long gamma in LOW than HD, so I wouldn't be dissuaded about the (-)edge implied by the lower volty in HD

    I'm not recommending this specific trade, but since you like the pairs trade, you may want to consider:

    Buying the LOW Apr 55C
    Selling the HD Apr 35C

    Now, if HD were to tender for LOW's shares, you'd have a huge winner, LOL. The risk is a runaway, co-specific move on HD, but the risk is miniscule

  3. thanks, riskarb. I was thinking in terms of using something that would put me behind the earnings, but I'd be trading it anyway so it probably makes more sense to use the Apr's.
  4. Yeah, figured you roll upon front month expiration, anyhoo.