3 Reasons to Pairs Trade with Options

07/21/2015 8:00 am EST

Focus: OPTIONS

The danger of pairs trading is that correlations can breakdown and actually add risk to a trade that was intended to reduce risk, so Andrew Falde, of SMB Training Blog, points out that a variation of this style of trading is to use options.

Pairs trading is a market neutral strategy that focuses on the correlation of two instruments rather than pure direction. For example, you may want to be long GOOGL and use a short QQQ position to offset your systemic risk.

Or you may see the relative weakness of IWM and look to trade it long against a short QQQ position for eventual mean reversion.

The danger of pairs trading is that correlations can breakdown and actually add risk to a trade that was intended to reduce risk.

A variation of this style of trading is to use options.

By using a derivative instrument, you can create strategies where your offsetting trade is tied directly to your core position, but you increase your odds because the nature of the paired trade has its own probability.

(you may want to read that last statement again)

Here are three reasons you may want to consider learning how to use options to boost your probability in pairs trading.

1. Premium decay can allow you to be right even when you’re wrong
2. Defined risk trades allow you to hold leverage overnight.
3. Options allow you to define risk without stop losses.

Andrew Falde, Contributor, SMB Training Blog

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