The “Pairs Trade” is a great way to play both sides of the market … in effect to stay neutral.
If stocks go up, down or sideways, you can still book winners.
One way you can achieve this neutrality is by using a paired-trade strategy, where you trade credit spreads on stocks that are highly correlated – one using a bullish put spread and the other a bearish call spread.
Picking the Stocks
Typically, I look for stocks in the same industry – for example, the biotech, health care, transportation, consumer discretionary and software sectors have been fertile ground for pairs trades during the past few months.
I can either pick two stocks from the same industry or go with an ETF paired with one of its top holdings.
The rationale underlying these trades is that both equities will track each other to a large degree. If that relationship holds, the performances of the positions will largely offset each other. But because both spreads are out of the money and have room for error, they should eventually expire worthless.
The fly in the ointment, of course, is a large move that pulls one of the positions into the money. But that’s a problem with any credit spread.
With pairs trades, however, we know that one loser is likely linked to a winner. And the odds against such a large move are in our favor.
A Profitable Pairs Trade
Let me show you an example of how these trades work so well.
The first trade on Broadcom (NASDAQ: AVGO) came during a Smart Option Income live trading session on recently. AVGO had pulled back by around 5% after a slight earnings miss a week earlier. But the stock had stabilized and had moving average support below to keep my spread out of the money.
With AVGO at $290 we entered the bullish 270/267.5 put spread expiring in about 25 days for a credit of $0.45. The trade was based on AVGO staying above the short 270 strike through expiration to achieve a maximum return of around 22% on margin. Thus, the stock could have dropped nearly 7% without the spread moving into the money and thus reducing our profit.
The other half of our semiconductor pairs trade came six days later with a bearish spread on Qualcomm (NASDAQ: QCOM). The stock had been moving sideways for three months, with the top of its range below the short strike of our call spread.
With the stock at $76.50, we entered the bearish 81/83.5 call spread expiring on Oct. 25 for a credit of $0.50. Our goal was for the trading range to continue and for QCOM to remain below 81 through expiration. That left just under 6% of wiggle room to be wrong on direction.
So, how did these trades turn out?
The results were great … stock picking aside. But the strategy made up for it. Let’s take a look …
AVGO quickly defied expectations by dropping below trendline support. In fact, the stock dipped as low as $267, well below the short strike, before recovering. But AVGO found its footing and drove higher to finish at $289.82, just below the entry price, on Oct. 25.
The spread expired worthless and we retained the entire 45-cent credit.
The return was a tidy 25% for a trade that lasted 30 days.
The Takeaways From This Pairs Trade
First, the pairs trade strategy worked.
Both stocks moved generally in the same direction without huge moves that could have knocked us out of the positions.
Both eventually expired worthless to yield 22% and 25% returns.
What’s more, we pocketed more than $1,100 in profits on trades that used less than 10% of our portfolio. However, the bearish QCOM trade outperformed the bullish AVGO trade.
And that underscores the value of trading out-of-the-money credit spreads.
There is room to be wrong and we needed just about all that space for both trades. AVGO dipped enough to move the spread into the money but recovered in time. The QCOM trade rallied toward the end and expired just in time.
The Lesson: You can trade with strategies that don’t rely on accurate stock picking. Credit spreads allow plenty of room for error and pairs trading puts the odds even more in your favor.
P.S. In LESS then 30 Minutes a Week you can create an “extra” $500 of weekly cash from ANY SIZE account following my “80-20” Trade Scan. Learn an option strategy that actually profits in any market!
About The Author
Meet Jon Lewis, With over 20 years of real experience, teaching AND trading, Jon will help you learn to use options profitably and safely in portfolios of any size.
His advantage, and now yours, is using simple, often overlooked spread options strategies which generate consistent income without significant risk.