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tagoma
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Joined: February 21st, 2010, 12:58 pm

Pair trading and options

December 3rd, 2021, 11:10 am

Hello Friends, Can you please recommend articles, books, blogs or even google keywords on options positioning in a pair trading setup? I'm looking for practical stuff. I'm not interested in hedging, and I don't want to buy/sell futures. I want to get the best out of options positioning as the spread between 2 assets I follow narrows/widens. Please tell me if this doesn't even make sense. Thank you.
 
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kc11415
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Re: Pair trading and options

December 10th, 2021, 8:15 pm

When you say "don't want... futures" does that include no synthetic futures? (eg. buy a call and sell a put, or vice versa)

When you say "pair trading" are you referring to a position where each leg is for a different underlying instrument ?

Or, are you referring to a combination of different expiration dates or different strike prices or a put & a call ?
My personal experience has been that folks refer to the latter as multi-legged positions rather than as pair trading.
(However, I've not stayed current and do NOT claim to be authoritative)

For those of us who have yet to gain proficiency in SDE/PDE, and do not have graduate coursework in Financial Engineering, Larry McMillan has been putting out options trading/investing books and other training materials that are accessible for highly motivated retail investors.
Sometimes he even shows up at trading conferences/conventions.
He has also put out a variety of training videos some of which I've seen and helped me get from completely ignorant up to apprentice level.
McMillan seems to 'straddle' the ambiguous boundary between trading vs investing.
For example, strategies like writing covered calls as a way for an investor to collect premiums from traders.
These kinds of strategies will not be of interest for everyone.
 
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tagoma
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Re: Pair trading and options

December 23rd, 2021, 3:07 pm

Hi kc. sorry for the reply i just saw your post. thank you for that.
synthetic futures are fine and yes these are 2 different underlying instruments.
thank you for the reference to McMilllan. I have never heard of him. i will search on the internet.
so maybe i shall rephrase (at the risk of adding a laying of blur) : say on my screen there is a chart showing the price action 2 security, and i expect these two animals now move closer/get further part.  question: are there typical options trading strategy/settings to benefit from the move of these 2 legs, leveraging options characteristics, etc.. ? (and say i'm allowed to trade options only, long and short, and these are basic calls and puts).
 
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kc11415
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Re: Pair trading and options

December 24th, 2021, 6:01 pm

I'm a little rusty on these topics so take with a grain of salt.  Nothing I say here should be taken as authoritative.
I assume many members of the forums know this stuff better than me and can spot multiple errors in what I say below, if they can be bothered to write them here.

you saying: tagoma: "allowed to trade options only, long and short, and these are basic calls and puts"
is really not enough detail for someone to answer your questions in a manner focused/directed upon your specific interests.
Question: Did you mean to say "allowed to BUY options only"  (that could imply a margin trading account is not part of the context for these questions. If so, then synthetic futures are likely off the table, as are many other types of multi-legged options positions.)

Hypothetically, it might be conceivable to write covered-calls in a cash account, though I've no experience in seeing anyone actually do that.
Aside from that, you can't sell/write/short options contracts in a cash account; only buy contracts.

OK, you probably should stop reading there. The remainder is TL;DR. Read further at your own peril :-)

Whether or not you have a margin account for trading options will affect which types of positions you can enter at any broker.
The amount of margin capital you have allocated for this trading account and the amount of credit your broker will allow based on that capital will also affect the kinds of positions your particular broker will allow you to enter.
Different legs of a position will tie up differing amounts of your margin capital.
An unlevered buy (go long) of a contract paid for with cash and not using a penny of margin; a broker will let you buy as many of those as you have unallocated trading capital to pay for, up to any regulatory limits.
That capital is now tied up and mostly/partly unavailable to use as capital pledged towards margined trades.
Some brokers will let you use some portion of that invested capital to pledge towards your basis for the size of other levered/margined positions they let you put on.

OK, so far most of the above is probably not new to you, but was a lead up to the following bit that might be new for you.

Where options starts to have some new concepts thrown in is that many brokers may let you lever much more heavily for positions such as: for the same underlying stock buy one put and sell another put (or same thing for calls).
Now if for that same underlying stock you put on a 4-legged position buy 1 put, sell 1 put, buy 1 call, sell 1 call, then you've effectively created a position with a pair of synthetic futures, one long & one short.  The difference for the two synthetics could be either strike price or expiration dates, but potentially heavily levered with only modest capital being allocated towards the margin on this trade.
You could then do the same thing for the other underlying stock, but in the opposite direction.

Q: would I actually advocate anyone to do this?
A: No, not for most people, especially not for novices.  (for multiple reasons)

An 8-legged position like this incurs multiple disadvantages:
1) You eat the cost of the bid/ask spread potentially up to 8 times, not just once or twice.
  (I've never sold a put contract so I don't know how losses work on the B/A spread)
2) There's a good chance you won't find your preferred contract at a reasonable price for each of the 8 legs, so you either must accept an inferior price, or substitute an alternate contract for that leg.
3) you are exposed to theta for your multiple long legs, hopefully offset by theta on your multiple short legs.
4) broker commission times 8, rather than times 1.
5) your broker might accept the order to put on this multi-legged trade, but not have the ability to fully execute it.
6) your broker might refuse to accept such an order from a small-fry or new account, or if they don't think you've got the ability to stay on top of it.
7) a highly-levered multi-legged position exposes you to volatility for each of the legs.  The allowed higher leverage is predicated upon an assumption that volatility will average out for a smoother overall volatility.  However, hypothetically there could be brief times when a few legs have wild swings not fully offset by other legs.  Hypothetically, this could result in a margin call  :-(
 
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kc11415
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Re: Pair trading and options

December 24th, 2021, 6:14 pm

If we are to assume a cash-only non-margined account, trying to approximate a pairs-trade spread-trade only buying puts & calls, then you might face multiple sources of trading friction/slippage:
1) You are a price-taker, not price-maker, so you eat the Bid/Ask spread on both sides, and when entering and exiting the trade.
2) You eat theta time-value decay on both "legs" of your "position"
3) While you might think of it as 1 position or trade, your broker likely won't, so each leg must be fully paid for in cash up front

Some advantage(s):
a) there's no way to get a margin call.
b) there's no leverage so you can't be whipped out of a position by volatility
c) this kind of trading could be eligible for use in a tax-deferred retirement account (IRA, etc) for which margin calls are really not allowed.