Pair trading with options

So, pair traders look for highly related stocks — such as stocks in the same industry, and often direct competitors — that begin to diverge in their price movements. These divergences can take place over a period of a few minutes intra-day, or over a period of weeks or months in the longer term. Under the assumption of market neutrality, pair traders expect that the underperforming stock will eventually return to neutral performance — which means a price increase.

Meanwhile, the same assumption for the overperforming stock indicates that a price decrease should occur. One of the major advantages to pair trading is that the assumption of market neutrality can be violated slightly and positions can still be profitable.

In an ideal scenario, traders will see the underperforming stock — which they are long on — increase in price, while the overperforming stock — which they are short on — decreases in price. The positions would then be closed out when the historical correlated relationship between the two stocks is resumed. But, traders can still profit even if only one stock moves. Conversely, even if the underperforming stock continues to underperform, as long as the overperforming stock drops in price the short position can yield a profit.

Correlation between t wo stocks is key to pair trading. Stocks are said to be perfectly correlated a correlation coefficient of 1 when they move exactly in sync. They are perfectly inversely correlated a correlation coefficient of -1 when they move exactly in sync, but in opposite directions.

When stocks have no correlation whatsoever, they have a correlation coefficient of 0. Sinc e pair traders are searching for stocks that are correlated as closely as possible in the same direction, many traders use a correlation coefficient of 0. An important part of assessing correlation is to identify a reason for the correlation.

Two stocks that are completely unrelated may be correlated, but if there is no explanation why that correlation could be random. So, most traders turn to stocks that have some relationship between them when looking for correlation.

That may be two direct competitors or two stocks in the same industry. Once a correlation is suspected, it is important to test it.

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Correlation can occur over multiple overlapping timeframes, and may not always be present. For this reason, back testing and forward testing is a n extremely important part of identifying correlated stocks.

Advanced Research

If a correlation does exist, it is possible to determine whether the stocks consistently revert to a mean relative value by checking the ratio of their prices over time. Fixed Pair Options close at a fixed expiry time. Option Start Time: For each stock pair, the relative performance of each stock is measured from the time you purchased the option.

This is also called the option start time. Option Expiry Time: Option expiry can be set to any time between one hour and days from purchase. Payouts are determined depending on the relative position of the underlying stocks and other market variables. Relative performance is measured from the time you placed the trade option start.

At the end of the day option expiry , relative performance is measured for the two stocks, neutralising the effect of market movements throughout the day. If British Telecom is the better performer, your payout is zero.

Scared of volatility?

When your positions are open, you will see the payout offered by the platform. If you close the position "sell" it it will payout the indicated value. Trading in Floating Pair Options: Floating Pair Options are contracts by which the better performing stock is determined by the Stock Pair's relative value at a predefined date and time usually beginning of a day, a week or month. The better performing stock is determined by the difference in value between the opening and the closing of your ownership.

Payout is at the set expiry time: end of day, week or month. When market trading is open, the platform shows a payout value in real time. You can close your position at a profit while trading is open before the original expiry time. Option Start Time: A Floating Option starts at the beginning of the trading period: day, week or month.

Option start time is fixed regardless of your trade start time. Your position value has to "catch up" with the other stock when your side is below the other side. If your side is leading, it has to maintain its position relative to the other stock.

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Option Expiry Time: Floating Pair Options are available with option expiry at the end of the day, week or month. Payouts are determined depending on time to expiry, the relative value of the underlying stocks and other market variables. You speculate on Apple outperforming Microsoft at the end of the day. Shadowtrader Pairs Trader Newsletter Daily newsletter for equity pairs traders with real-time text alerts on all entries, exits, and stops. Read Now. Weekly one hour interactive program for pairs traders of all levels.

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