Scalping is a strategy we can use to keep us engaged and keep our Market Awareness sharp during periods of low Implied Volatility (IV). A Pairs Trade can do the same thing and as Tom said, “As soon as you reduce risk and extend duration you have what I think is an interesting cyclical trade. It is also an interesting engagement tool. It’s like scalping with less risk.” How do we find candidates for a Pairs Trade and once we find the candidates how do we structure the trade?
We find stocks for a good Pairs Trade by seeking out liquid underlyings which are well correlated over the longer run but which have recently diverged. Once we have our pair we determine the notional value of each underlying. We then adjust the notional value by IV. The final step is to determine the contract ratio which best matches the IV adjusted notional value.
American Airlines (AAL) and Southwest Airlines (LUV) are two well correlated stocks that have recently diverged. The 12 month correlation is 0.75 but the relationship, as seen on a chart, diverged in July when AAL rose in price and LUV declined. We then take the current price of each stock and multiply it by 100 (for a round lot and equal to an options contract) for the notional value. We then take each separate notional value and multiply it by the IV of the underlying. Dividing the larger adjusted notional value by the smaller gives us a ratio which in this case is about 1.29:1. A ratio of 4:3 equates to 1.33:1 and is more than close enough for a Pairs Trade. Tables provide the figures for each step. A final table listed two different option trades we could use. Using options means the margin and resulting Buying Power Reduction (BPR) is less. It also adds Theta (time decay) into the mix.
For more information on Pairs Trades see:
Best Practices from November 10, 2014: "Pairs Trading"
Market Measures from January 8, 2015: "How To | Pairs Trade"
Best Practices from August 31, 2015: "Pairs Trade"
Best Practices from August 8, 2016: "Pairs Trading Price Volatility"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for a step by step guide on how to find and construct a Pairs Trade.
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