Pairs trading with options

M

maninjapan

I'm in the process of developing a pairs system using non directional/ delta neutral option strategies and trying to figure out the best way to calculate position sizing. WIth equities, I can just purchase an equal dollar amount of shares. If I was straight puts or calls I could trade equal amounts of delta. But in this case the trade is delta neutral (at least when I put it on) meaning I need to look somewhere else.... Has anyone had any experience with these strategies, used a position sizing technique that may be transferrable or know of any academic material that might cover something similar?


Thanks in advance!!
 
Rosy, yeah, between different equities/ETFs. I actually did a few tests based on vega, but was worried that by focusing on vega, I'm taking too much risk in my actual exposure to each position.
Any particular reason why you suggest vega?
 
If you use ATM options, just make it neutral in implied volatility. Meaning the amount of implied you buy in one is equal to the amount of implied you take in the other. My sense is that you may already have that in your pairs ratio?

In option you need also to decide if you will be short or long volty. You can be long in both, short in one and long in the other, or short both.

Describe your pair in more details, showing charts of the pair if possible.
 
Tradingjournals, I was actually selling equal amounts of vega. Do you mean if IV of A is 20 and IV of B is 10, then sell 200 sets of B and sell 100 sets of A??
 
Yes, that would make you delta neutral assuming you are selling calls on both, or puts on both.

The dollar amounts would also be equal. Try it and comment on your findings.

What is your hedge ratio in the pair?
 
Quote from tradingjournals:
If you use ATM options, just make it neutral in implied volatility. Meaning the amount of implied you buy in one is equal to the amount of implied you take in the other.
More...
This is utter nonsense... What do you mean by "neutral in implied volatility"? What does "the amount of implied you buy" mean? Do you mean premium-neutral?

m-in-j, I have two bits of advice to contribute. Firstly, you must ignore silliness like the above post. Secondly, you need to realize that your strtegy involves trading two factors, the balancing of which may at times be mutually exclusive. Personally, as I mentioned before, I don't know much about equities, but having done these sorts of trades in my world, I can tell about my experience. The first rule is to use weights that make sure you're flat the first factor (say direction or beta or whatever you define it to be), if both the options expire ITM. Once you do that, the vol bit is the analytical extra step that will allow you to pick strikes and to decide whether the trade makes sense or not (you can look at vol ratios, implied correlation, etc).

My 2c. Again, apologies if this isn't of relevance to the world of equities.
 
Quote from Martinghoul:

..What do you mean by "neutral in implied volatility"? What does "the amount of implied you buy" mean? Do you mean premium-neutral?
More...

What do you mean by neutral (you used it in premium-neutral without quotes)?
 
Quote from tradingjournals:
What do you mean by neutral (you used it in premium-neutral without quotes)?
More...
I define a multiple leg option trade as "premium-neutral", if and only if the net premium (expressed as the actual $ settlement amt) paid or received is zero. I thought the term is unambiguous, but I guess I was wrong.
 
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