Stocks and options. If you can’t short
stock, you may choose to buy a put option
instead. The position sizing and selection
is a tad more complicated thanks to time
decay and the leverage of options. But it
can be a lower-cost way to mimic a short
position without needing to pony up the
Theoretically, you might buy one stock
and pair it with a naked short call option
on another stock in the same sector (
instead of shorting the stock). For example,
you may still want to be long XYZ stock.
But rather than sell ZYX short, you may
opt to sell a ZYX out-of-the-money call
Although your position might look like
a covered call, you don’t own the stock
on which you’ve sold the call. So to trade
this strategy, you must be approved to
trade naked short call options, which
naturally carry inherent risks and capital
Options and options. What if rather
than buying one stock and selling another,
you opted to buy a call option on one stock
and a put on the other?
This may seem attractive because of
the lower cost, lower options tiers, and
lower requirements. Yet, there can be
other risks. Although you may not have
much directional (delta) risk, you are in
fact long two options. That means you
could have daily decay (theta), which
can get expensive with two long options
positions as the days pass. If you like this
approach, you may want to consider deep
in-the-money options. The higher deltas
and lower time decay could mitigate your
So, where doesn’t a pairs trade work
well with options? You may want to avoid
pairs trading on options spreads. The dy-
namics built into the profit curve of limit-
ed-risk strategies, such as vertical spreads
and the like, can make profiting from a
pairs trade di;cult.
AS WITH EVERY THING IN TRADING,
there’s no one right path. No magic bullet
that guarantees the precise outcome you
desire. That said, pairs trading can be
adaptive, fluid, and useful. Pairs trades are
not without challenges, but they may still
be worth considering. Bringing them into
your vocabulary could be just what the
sandwich chef had in mind.
Kevin Lund is not a representative of TD Ameritrade,
Inc. The material, views, and opinions expressed in
this article are solely those of the author and may
not be reflective of those held by TD Ameritrade, Inc.
For more on the risks of trading options, see
page 38, #1– 2.
Options naked call: The risk of loss on an uncovered
call options position is potentially unlimited since
there is no limit to the price increase of the underlying security. Naked options strategies involve the
highest amount of risk and are only appropriate for
traders with the highest risk tolerance.
To get started, choose two similar stocks in the same sector
that exhibit comparable and consistent percentage moves
over a specified time period (at least a year). You can do this
on the thinkorswim® platform from TD;Ameritrade.
The quickest way to chart two stocks in a pair is to simply subtract the
symbol of the short stock from the symbol of the long stock (e.g., enter
“XYZ–ZYX”). The resulting chart will display the di;erence in prices across
any period of time.
Alternatively, you could use the Pairs Trader tool under the Trade tab of
1. Find the Studies button in the upper-right corner.
2. Select it, then hold the cursor over Quick Study. You’ll see a menu with
3. On the bottom right of that menu, you’ll see the words Compare With.
4. You’ll then see a list of default index symbols such as DJX and SPX, as
well as Custom Symbol near the top of that menu.
5. Under Custom Symbol, select the stock you’d like to compare to the
6. Your chart will reflect both symbols overlaid for your desired time
period, making it easy to spot current and prior gaps where the stocks
traded uncorrelated and the resulting price action.
HOW TO PICK
A PAIRS TRADE