Hunting for Hedges: A Primer on Option Pairs Trading

The following article, written by Bernie Schaeffer and Todd Salamone, is from the summer 2009 issue of SENTIMENT magazine, which is designed specifically for those interested in trading options. Every issue of SENTIMENT includes educational pieces for newcomers to options trading, as well as advanced strategy stories to help experienced traders build their portfolios. Please click here if you would like to receive your own copy of the next quarterly issue of SENTIMENT.

Can you picture yourself in the following situation? Suppose you love the potential upside on a certain stock, and you're confident about its ability to outperform. However, you are unsure about the direction of the next big move in the industry sector—or, for that matter, in the broader market. Should you leave money on the table and shy away from what may prove to be a profitable trade? Or should you take the trade and risk being blindsided by an unpredictable event that could have an extremely adverse effect on your stock or option position?

The most successful professional traders are open to the fact that both possibilities exist, and they take action to both manage risk and profit from the opportunities that they identify. So, how can you seize opportunities while managing your risk in these uncertain times?

The answer may lie in a strategy that we at Schaeffer's have found extremely powerful (and profitable) over the past few years known as option pairs trading. With this strategy, you buy a call option on a stock you like and hedge that call position by simultaneously buying a put option on a different stock within the same sector.

The appeal of the option pairs trading strategy—compared to stock trading—is that you can commit significantly less money to the market but still retain a strong profit potential in both up and down markets.

For options traders, the option pairs trading approach can improve your option-buying win percentage and reduce your average loss by positioning you to better withstand—or even profit from—unexpected sector or market moves.

Utilizing the option pairs trading strategy will help you sleep better at night because (1) you can profit from big moves in either direction; (2) you are using options as a leveraged vehicle, with significantly less money at risk compared to trading stocks; and (3) your risk is better defined (the most you can lose is the smaller premiums paid for the options versus outright stock pairs trades).

There are three ways for you to profit from this option pairs trading strategy: First, if the underlying stock on which you buy the call (primary stock) outperforms the underlying stock on which you purchase the put, regardless of market or sector direction. In this scenario, it's possible that both stocks will move in the same direction or diverge.

Second, if there is a huge upside or downside move in the sector or in the market, causing one of the two options in the put and call pair to more than double in price. This guarantees you a profit on the options pair trade.

Third, if the underlying stocks of each position in the put and call pair move in the direction you anticipated, allowing you to profit from both options.

Let's break down each of the three scenarios with a hypothetical example.

Primary Stock Outperforms Hedge; Both Stocks Go Down

As an example of profit scenario number one, assume you are bullish on Juniper Networks (JNPR) and buy JNPR call options. Since you are uncertain where technology stocks are headed, instead of putting all your eggs in the JNPR call basket, you hedge your call exposure by purchasing put options on the Nasdaq 100 Trust (QQQQ). Assume you put equal dollars into these put and call positions and the options you purchase give you leverage of about five to one, which means the percentage gains and losses on the options are about five times the percentage moves of JNPR and QQQQ shares.

To calculate the leverage of an option relative to its underlying, you simply use the formula:

(Stock price X Option delta) ÷ Option price

For example, if JNPR is trading at $24, and an at-the-money call (typically .50 delta) is $2.40, then [(24 X .50) ÷ 2.40] = 5.

During your holding period, JNPR declines by 7%, while the QQQQ experiences a 14% setback. While you take a loss on the JNPR call of roughly 35% (5 times 7%), your gain on the QQQQ put option is about 70% (5 times 14%). Your net profit on this pairs trade, assuming equal dollars in the call and the put, is 17.5%. Note that had you purchased only JNPR calls, you would have lost 35%. But with the purchase of QQQQ puts to create a pair, you profited, since JNPR outperformed the QQQQ. The profit from the put option exceeded the loss from the call option.

To recap this pairs trade:

JNPR call -35%
QQQQ put +70%
Net profit +17.5%

Primary stocks goes up, hedge stock goes down

Now let's suppose you are correct about JNPR, and the shares advance by 15% as the QQQQ drifts higher by 5%. Once again assuming five-to-one leverage on the options you purchased, your JNPR call is up 75%, the QQQQ put is in the red by 25%, and you have a net profit of 25%. While you didn't make as much money in this situation as with simply purchasing the JNPR call, you took on less risk to achieve the profit. In other words, you profited from your bullish view on JNPR regardless of the direction technology stocks took during your holding period.

To recap this pairs trade:

JNPR call +75%
QQQQ put -25%
Net profit +25%

Powerful Move in the Sector

Let's move on to profit scenario number two, which involves an explosive move (higher or lower) in the sector you are trading. We have certainly seen explosive moves in recent months, from the broader market down to sectors such as the financial and retail groups. This profit scenario is particularly interesting in trading option pairs, since you can be wrong about the direction of a stock or about the equity's performance relative to another equity or index, but still make money. In such market environments, trading option pairs gives you a clear advantage over stock traders employing a long/short strategy. This is because options buyers can take advantage of a concept called convexity, which means the profit potential of a long option position is a multiple of the maximum risk.

Table 1 illustrates the advantage of the option pairs strategy relative to the long/short stock strategy. Again, the investor is bullish on JNPR, but is uncertain as to the direction of the technology sector. The options pair trader buys JNPR calls and hedges by buying QQQQ puts. The long/short player buys shares of JNPR and shorts QQQQ shares.

In scenario A, technology stocks and JNPR explode higher. The takeaway here is that huge profits are possible, since options allow you to make many times your capital commitment—and the most you can lose is what's invested in the option. The 75% profit on the options pair is huge relative to the 10% gain in the long/short strategy.

In scenario B, technology stocks take a big tumble. Note here that with an options pair trade, you can be wrong about your stock price forecast, but still make money if volatility is high. The 40% plunge in JNPR shares amid a 30% decline in the QQQQ resulted in a net 25% profit in the options pair because risk to the option buyer is truncated, while potential profits are not. Note that the long/short stock player lost money in this situation. What is there not to like about this type of profit possibility? Call it the "oops, but I made money anyway!" profit. You were wrong on direction, but right on volatility. And one of the few ways you can profit in such situations is by trading option pairs.

Primary Stock Goes Up, Hedge Stock Goes Down—the Best of Both Worlds

The third and final profit scenario occurs when you profit from both your call and your put positions. In other words, the underlying stock on which you purchased the put moves sufficiently lower, while the underlying stock on which you bought the call moves sufficiently higher. Using our JNPR call/QQQQ put example, the JNPR call would be profitable and the QQQQ put would be profitable, as JNPR rallies amid broader technology weakness. In this scenario, your stock forecast was perfect and you are rewarded accordingly.

Minor Caveats

As with any investing strategy, you will have losing trades using option pairs. The put underlying may outperform the call underlying, or both positions might move against you. However, in most cases the losses will tend to be small, since you are hedging your directional view. The advantages clearly outweigh the disadvantages in option pairs trading. The advantages include profiting from relative strength trends within sectors; profiting from surges in volatility; the possibility of profiting on both the put and the call; and sleeping better at night, with less worry about unexpected market scenarios. The major disadvantage of option pairs trading is that you are "double long" option premium, and thus your position has heightened vulnerability to time decay. Should the component stocks underlying your pair remain flat, your option pair trade will experience time decay loss.

Note that the option pairs strategy in itself will not make you money. You have to be equipped to identify stocks that can outperform or underperform and have the skills to find potentially volatile situations. We invite you to view our accompanying video on this topic, as we'll give you some tips that can increase your chances of profiting with this approach. And remember, "good things come in pairs!"