LV14042 Pair Trading with Options Jeff Donaldson, Ph.D., CFA University of Tampa Donald Flagg, Ph.D. University of Tampa Ashley Northrup University of Tampa Student Type of Research: Pedagogy Disciplines of Interest: Finance and Investments LV14042 Pair Trading with Options Abstract Options are an easy concept to discuss but very are very difficult one to put into practice. In this exercise students are challenged to use different option strategies in a pair-trading framework. With market volatility high and after the stock market fallout in 2008, pair trading has gained much attention. Students have also become interested in this more complex way of trading. This exercise combines the concepts of both pair trading and options to create an experiential learning experience for students. Students will create their own pair trade and then use an option strategy to make a pair trade. Options allow the investor to eliminate the downside risks of a typical pair trade but also add complexities such as time decay of option premiums. The exercise provides students with the ability to explore option strategies in a real-world trading scenario examining premiums over time instead of a static problem set only thinking about the valuation of options at expiration. LV14042 Finance students are both confused and excited about options and the use of options. Although the initial understanding of options is achievable through traditional lecturing and option problem sets, the real understanding of options is only understood through the use of options in different scenarios. In this exercise, students are placed in a real world-trading environment to test their knowledge of option strategies and witness how these strategies work using historical option data. In this paper we integrate the use of option strategies with the idea of pair trading. Pair trading is not a new concept but with market volatility at all time highs, pair trading has gained attention within the trading community and has filtered its way to the retail investing public. With retail traders hearing more about pair trading students have begun to gain interest in this topic as well. Pair trading is a market neutral trading strategy, which enables traders to profit under virtually any market conditions. The direction of the market has no apparent affect on the trade. Usually most courses in Finance have limited coverage on pair trading. Pair trading typically involves pairing a long position in a stock with a short position in another stock. Of course the long position is one that an investor feels will increase and the short one is a stock the investor would feel is inferior. Pair trading typically involves two similar firms or ETFs. Since most investors and students are long only investors the idea of pair trading is sometimes a hard one to grasp. Shorting a stock is sometimes thought as a more dangerous position than being long (or owning) a stock. Theoretically this is true as a short position can lose an infinite amount of money. We introduce the use of options within the framework of pair trading. Trading with options versus stock allows for different risk/return tradeoffs. Options can be used to LV14042 limit the downside risk of the short component of the pair trade, thus making a pair trade with options can better define the risk of downside of the pair trade, which as mentioned above is unlimited as it relates to the short position. In the exercise students come up with a hypothetical pair trade and then create an option strategy to take advantage of the pair trade. One potential selection for the option trade is a straddle pair trade. This involves the purchase of a call on the stock believed to go up and purchasing a put on the stock believed to drop. Students can explore different option strategies and then back test their trading strategy and the success of the pair trade by looking at the equity only returns versus that of options from their pair trade selected. This exercise provides students with an experiential learning method to numerous different learning objectives. Instead of just learning about options and pair trades students learn by developing trades and testing them. Students will analyze different option strategies and examine investments in a pair-trading framework. Also, be able to examine portfolio and risk management in an option framework. Finally, it allows students to reflect on their option strategy and pair trade to measure their success in understanding the concept of options and pair trading. This exercise would be a particular good fit for any Investment course or in a Financial Markets course. It could also used with currencies and currency options for an International Finance course. This would most likely be used in a graduate course, but could be adapted for an undergraduate course as well if simplified. This exercise would also be a perfect compliment with the Black-Scholes model. Students can se actual option premiums and how they are impacted by the variables within the Black-Scholes model. As students set up a trading strategy they can see the importance of what impacts option LV14042 premiums. This paper proceeds as follows: Section two explains the related literature. Section three explains how to conduct the exercise and provides the instructor notes for the exercise. Section four provides sample pair trades using options and tables showing the results of those trades. Section five concludes. II. Literature Review Preston (2011) discusses the logic of the pair trade, which is to make money on the fluctuations in price between the two stocks (or whichever instrument is used). If both stocks increase, but the long position increases faster relative to the short position, you will have losses on the short position and gains on the long position; the profits would exceed the losses here if the long position were greater than the short position. The idea he points out is that the logic of pairs trading can be quite simple, though the actual trading can become complex. An investor needs to know the logic of the trade and indicators he is looking for before he can make his trades successful. He further argues that the correlation (relative strength) between the two stocks needs to be positive. If there is a positive correlation between the two stocks and the two stocks are correlated to the market, an increase in the market will cause a movement of the same magnitude for each stock. For highly uncorrelated stocks, a change in the market will not lead to the desired change and could lead to disastrous effects. Preston’s main focus is that the pair needs to be at a higher spread than usual. It needs to be an unusual event that an investor can take advantage of as the spread reverts to its mean. You buy the stock that is relatively cheap, sell the stock that is relatively expensive, and speculate that the long position will rise relative to the short position. LV14042 Preston states that as the spread reverts “the speculation behind the pairs trade has been met and it is wise to close it out with a profit or loss” ( Traders-Mag.com , p.44). Though these trades take much patience and knowledge, it is an opportunity to make a profit whether the market is going up or down; just find a pair that has a spread that reverted from its mean (prices above and below the normal range) and speculate on the trade reverting to its mean over a period of time. Whether you are trading equities or derivative instruments such as options, the same principles apply and profits may be realized. Chang and Chang (2011) discuss the biases in the different methods of calculating prices, so with a superior pricing formula, some biases should be removed. They conclude that the information-time formula outperforms Merton’s diffusion-jump formula in explaining Black-Scholes biases, but is less satisfactory in the case of stock options. They suggest that transaction counts or trading volume should affect asset prices and that information-time pricing should be a valuable alternative to the traditional calendar-time pricing. Gatev et al (2006) discusses the performance of pairs trading and the arbitrage opportunities presented to investors who trade pairs. They begin by stating that the excess returns of pairs trading are a result of temporary mispricing. In their study, they found that the profits from the pairs they chose were uncorrelated with the S&P 500, but were slightly sensitive to the spreads between small and large stocks and between value and growth stocks. Their claim is that excess returns are related to the mispricing of stocks. They showed in their research that the profits were not due simply to mean reversion alone. In that case, one would expect the returns of both the short and the long positions LV14042 to be equal. Thus, there are more factors than mere mean reversion to consider in a successful pairs trade. III. Instructor Notes / Student Exercise Lectures of both pair trading and of options would precede this exercise. Some extra readings can be assigned including the references in this paper to increase student understanding. The idea of pair trading will be explained to students including explaining how to setup a pair trade and how it works. A typical pair trade is buying one stock you think will increase while at the same time selling a stock in a similar industry, sector, or market direction. The design of most pair trades is to take advantage of some mispricing or fundamental swing in prices of stocks. Students will also need to understand how options work to make a pair trade using options.