Pairs Trading Using Options
04/01/2013 8:00 am EST
It is necessary to weigh the inputs, the difference in stock price, and any upcoming events in trying construct a balanced paired position, writes Steve Smith on Minyanville.com, and options can make that process a lot easier.
Whenever I find myself at the roulette wheel, I typically play the outside, trying to hedge myself by betting on two of the 50% (okay, it is 47.4% with the green "0" and "00") such as even or red. My wishful thinking is that not only should one of the two come up, but I could potentially win on both. Of course, I could also lose on both. It is likewise with paired trades, which can give the impression of a hedged position, but actually give you two ways to lose as surely as two ways to win.
A paired position is typically constructed by going long a specific security and simultaneously shorting a related issue. Some examples of classic paired trades would be Coke (KO) vs. Pepsi (PEP), Lowe’s (LOW) vs. Home Depot (HD), or even gold (GLD) vs. silver (SLV). The idea is to try to identify a mispricing based on valuation, upcoming catalysts, or technical analysis. The goal is to arbitrage this seeming price differential while assuming that any macro move for the sector will impact both securities in much the same way and therefore minimize losses. For example, if housing continues to recover, both Lowe’s and Home Depot should move higher.
But as noted above, these pairs can also lose two ways. And unlike the roulette wheel, which is a purely mechanical game of chance whose probabilities should revert to the mean over time, the stock picking business is dependent on numerous variables. This presents several challenges in setting up the pair. Are the reasons for differentials in stock price performance based on valuation, product pipeline, management, technical factors, fundamental factors, or a combination of these factors?
This means that it is necessary to weigh the inputs, the difference in stock price, and any upcoming events in trying construct a balanced paired position. As always, options can make that process a lot easier.
Pairing With Options
By using options to create a paired position, compared to going long and short the underlying securities, one can lower the cost of the initial outlay and therefore lower the total risk. It’s also easier to create a balance or tilt the trades with a minor adjustment.
For starters, I would suggest simply buying calls on the name you like (bullish) and buying puts on the name you think is overpriced relative to the former (bearish). By doing so, you have a defined cost or risk equal to the amount of premium paid, and you can tailor the number of contracts and their strike prices to create a customized pair rather than the more binomial long/short stock. Here are two paired positions that I’m looking at.
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These are two online brokers that would seemingly benefit from this bull market pulling money off the sidelines and putting in back into actively traded accounts. AMTD's stock price has certainly anticipated such a turn as its share price has climbed some 28% year to date. Meanwhile, IBKR, which caters to more sophisticated trades, has only seen a modest 11.5% gain year to date. While money flows are slowly showing a slight shift from bonds to equities, there has been no noticeable uptick in daily average revenue per trade (DART), a key metric for online brokers. It seems the shift in money is moving towards ETFs or wealth managers. My thesis is that the true active traders will opt for the low cost and superior platform provided by Interactive Brokers if trading volume truly picks up.
Under the hood, we see that AMTD trades at 21x forward P/E with a respectable 22% profit margin. By comparison, IBKR trades at just 11x forward P/E with a similar profit margin. The hole in IBKR is its balance sheet; it has a hefty debt load that leaves its book and enterprise value teetering on negative numbers. But if trading volume were to pick up, I think IBKR would benefit more since it caters to more active traders.
I’m looking at buying the Interactive Brokers May $15 calls for $0.30 per contract, then simultaneously buying an equal number of the TD Ameritrade May $18 puts for $0.25 per contract. This is a pretty clean pair in that both strikes are less than 1% out-of the-money and have similar notional values around $0.30 per contract. The deltas offset each other and so do those notional values. The biggest enemy will be time.
Given the fact that paired trades are something of a thematic call based on management, product pipelines, or cyclical themes, I’d suggest using options that have at least three to even nine months remaining until expiration.
This would be a valuation play. Kors has gotten a lot of love lately, and it now trades at with a 32x trailing P/E. One time highflier Coach has been benched with an 11x trailing P/E. This is too big of a discrepancy for me. Kors may be hot, but Coach is a stable benchmark brand. Recent numbers show that Coach has been seeing growth in Asia. I’ll be looking for a long Coach and short Kors pairs trade in the coming days.
Remember when pairing positions to keep it in balance and keep risk in check.
By Steve Smith, Reporter, Minyanville