Pair Trading with Options

Quote from Zimbu:

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.
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A fee per share broker would be better than a fee per transaction. At IB, other than a $1 minimum ticket, the equity fee is 50 cts per hundred shares versus 60 cts per option. The added benefit of a fee per share is that you can scale in and out at no commission penalty. A fee per transaction only makes sense if you're trading large share positions.

Or there's plan B: find pairs that move more than $1 - $3 :)
 
Quote from Zimbu:

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.
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Earning money with OTM options is not that simple. Open a practice account and trade OTM options in at least 20-lots. Then see how easy it is to get out for a profit. And don't forget the options on the other stock. You must avoid a loss in that side.

Mark
 
Quote from Zimbu:

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.
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The more I think about this, the less feasible it seems to me.

It's almost impossible to quantify the behavior of options on two different stocks. It's hard enough with one position on one stock. So maybe let's loosely extrapolate a pair possibility from how options on one stock might behave.

As a hypothetical example, assume you have two stocks at the same price with the same IV. I know, it's asking a lot and I'm not done asking (g).

Consider a long strangle at the parity mid point (or whatever you call it) where the put and call prices are equal. Say the stock is 52 and you buy a Sep 50p/55c strangle (Aug series is a high probability loser and so is anything further OTM). The delta of these options is going to be in the vicinity of 40. Let's say the move takes 1/2 the time until exp. That means about 40% of the premium will be lost due to time decay. Delta will be probably now be in the mid 30's.

If you start off with a $5 strangle and it loses 40% of its value in 3 weeks, it's worth $3. If the delta is 35, breakeven will be in the vicinity of 6 points higher or lower ($2 loss divided by .35). For lower IV stocks, it might be 4+ pts since they cost less, time decay loss is less and once ITM, they recover that loss sooner. For higher IV stocks, it could be 8+ pts. That's an awful lot to ask for in 3 weeks.

All of this is rule of thumb calculations. But if it's anywhere near the ball park, IMHO it's way too much to expect to overcome. So when I have the time, I'm going to explore my aforementioned put (or call) protected long ( or short) stock pair idea.
 
Quote from Zimbu:

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) ;)
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You may want to look what Financial Spread Betting is.
http://en.wikipedia.org/wiki/Spread_betting
And BTW, "It is illegal for a US citizen to use CFD or Spread Betting because they are regarded as gambling under US law".
I call this protectionism, or if you will constraints but a sure obstacle to free will IMO.
 
Quote from spindr0:

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 :)
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Thanks, I guess that is better but still doesn't feel the way a pair trade should. You could make money on a big move even if the spread widened or lose on implied vol and theta with a converging spread. I think I just like your fantasy trade idea without a pair attached better!
 
I can think of one option use in pairs trading I like though. Put a wide near-costless collar both stocks. So if one stock gets bought out or something your pair loss is limited. Pair trading is usually a lot of little gains with a few big losses, capping the big losses would be nice. But maybe not worth the transaction costs.
 
Thinking a little further, I can see now that OTM options have no intrinsic value, only time value, and time value inevitably goes away... ie, it's impossible to make money on an OTM option unless it goes ITM, which is not what I was looking at.

All in all, it seems clear that options are not a viable way to synthesize leverage for the purpose of pair trading. Of all of the comments on this thread (from folks with much more knowledge and experience than I) not one has truly supported the idea, and most knock it down pretty convincingly.

I believe I'll either need to raise more capital or find a brokerage with low-low commissions and liberal margin policies. Wish me luck!

Thanks for all the feedback.

Brian-
 
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