Pairs Trading: The Third Dimension of Trading

We do our best to get it right. And most of the time, we choose a trade based on where we think a stock will go—that is, up or down. But there’s more to trading than just trends. There’s also correlation. That maybe geek-speak to some. But to a pairs trader, correlation is, well, just about everything.

For starters, what’s a pairs trade? Imagine ordering a peanut butter and jelly sandwich for lunch (not swanky, I know). If there’s too much peanut butter, your tongue sticks to the roof of your mouth. Too much jelly, and it’s falling into your lap. Either way, you might want to get it fixed so it’s in line with expectations. At the end of it all, your new sandwich finds harmony and your mouth benefits. Bon appétit.

This is pairs trading. Two stocks in the same sector are generally expected to trade in harmony, that is, in a similar fashion. In other words, they’re said to correlate. Think Coke and Pepsi, or Ford and GM. Depending on the news for each, day-to-day fluctuations might look a little different. But over time, you’re hoping they’re going to trade in line with one another.

When one stock starts to trade a little out of whack and stray from the norm, the two stocks are said to be “uncorrelated,” creating a wider price gap between them. Here’s where opportunity might emerge—assuming the gap will eventually close, and the pair will find harmony again.

Opposites Can Attract

In a pairs trade, you take opposite positions in two different, yet similar, securities. You might take a bullish position on one stock and a bearish position on the other. The overall objective is to make money on the relative price movements between the pair.

For example, if the stock you bought rises in value, while the stock you sold short stays the same or even drops in value, you may end up with a profit. Sound simple? It’s critical to remember that for pairs trading to work best, it’s about relative price moves, not actual stock prices.

Pairs trades can present potential opportunities because the relative price movements between two correlated stocks may suddenly diverge. Above all, you might expect the two stocks will eventually correlate again, causing the relative price gap to revert back to “normal.”

Sizing Things Up

To capitalize on relative price moves between two stocks, a little math is needed so you’re comparing apples to apples.

For instance, XYZ stock may be trading at $50. But ZYX could be trading at $100. Here, you simply divide the price of the larger stock by that of the smaller stock to approximate a ratio (2:1 in this example). Then, you’d trade two shares of the lower-priced stock for every share of the higher-priced stock. Because the percentage moves are similar, you would expect to see $100 worth of long stock in one company paired against $100 of short stock in the other company.

Here’s another angle. Let’s assume you want to invest $2,000 in the trade. Splitting the difference, you can commit $1,000 to each position. It probably won’t be a perfect 2:1 ratio, so simply divide $1,000 by the stock price. If XYZ is trading at $40 and ZYX is at $60, you’d pair 25 shares of XYZ with 16 shares of ZYX.

Buying and Selling

Let’s assume that stocks XYZ and ZYX are in the same sector. For most of the past 60 days, you note they’ve traded in tandem. But for the past week, you see that ZYX is moving faster than XYZ. You may record this as a widening difference in prices on the chart. And it could be that XYZ typically trades slightly lower than ZYX. Assuming an eventual convergence, you may decide to take action and buy XYZ while selling ZYX in order to take advantage of what looks like a temporary divergence. You might profit from this trade if:

1. XYZ rises again more quickly than ZYX
2. ZYX falls faster than XYZ
3. XYZ rises and ZYX falls

In all three scenarios, the relative price gap between the two stocks closes, and you potentially profit from the trade. However, should the opposite of any of these scenarios occur, you could lose money instead.

Alternative Pairs

You’ve probably guessed that you’re not limited to pairing stock positions. In fact, you can use a combination of ETFs, futures, and options as well.

Stocks and ETFs. Often, you don’t have to look any further than a stock that becomes uncorrelated to its relative sector. Or you might buy or sell a stock and pair it with a long or short correlating sector ETF.

Stocks and options. If you can’t short stock, you may choose to buy a put option instead. The position sizing and selection is a tad more complicated thanks to time decay and the leverage of options. But it can be a lower-cost way to mimic a short position without needing to pony up the margin.

Theoretically, you might buy one stock and pair it with a naked short call option on another stock in the same sector (instead of shorting the stock). For example, you may still want to be long XYZ stock. But rather than sell ZYX short, you may opt to sell a ZYX out-of-the-money call option.

Although your position might look like a covered call, you don’t own the stock on which you’ve sold the call. So to trade this strategy, you must be approved to trade naked short call options, which carry potentially unlimited risks and large capital requirements.

Options and options. What if rather than buying one stock and selling another, you opted to buy a call option on one stock and a put on the other?

This may seem attractive because of the lower cost, lower options tiers, and lower requirements. Yet, there can be other risks. Although you may not have much directional (delta) risk, you are in fact long two options. That means you could have daily decay (theta), which can get expensive with two long options positions as the days pass. You could also end up long or short the stock at expiration if you don’t actively monitor, and don’t or can’t sell to close the options positions. Another risk to consider is the options could expire worthless and you would lose the entire premiums paid on them. If you like this approach, you may want to consider deep in-the-money options. The higher deltas and lower time decay could help address some of your options risk.

So, where doesn’t a pairs trade work well with options? You may want to avoid pairs trading on options spreads. The dynamics built into the profit curve of limited-risk strategies, such as vertical spreads and the like, can make profiting from a pairs trade difficult.

As with everything in trading, there’s no one right path. No magic bullet that guarantees the precise outcome you desire. That said, pairs trading can be adaptive, fluid, and useful. Pairs trades are not without challenges and risks, but they may still be worth considering. Bringing them into your vocabulary could be just what the sandwich chef had in mind.

Options naked call: The risk of loss on an uncovered call options position is potentially unlimited since there is no limit to the price increase of the underlying security. Naked options strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.