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Paired Trades: Using Options to Reduce Risk

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In 2013, the rising tide lifted almost all boats as 9 out the 10 major S&P 500 (INDEXSP:.INX) sectors all enjoyed double-digit increases, propelling the overall index to a whopping 30% gain.

But expectations for the coming year are more subdued and active money managers, most of whom underperformed their benchmarks in 2013, are crowing that 2014 will be "a stock picker's market" as correlations will decline.

But one way to combine stock picking with correlation analysis is to established a paired position.

This strategy involves simultaneously going long one stock and shorting another name in the same sector, or even a direct competitor.

The idea is that the gains one one side of trade will outperform the other. A classic example would be Coca-Cola (NYSE:KO) with Pepsi (NYSE:PEP). A more up-to-date and higher octane example might be trading Facebook (NASDAQ:FB) against Twitter (NASDAQ:TWTR).

But beware: The assumption that there's a high level of price correlation between two equities often leads to a false sense of security that a paired trade is less risky than being outright long or short a single issue. The reality is that a paired trade, while offering some diversification through the expectations of correlation, is not a hedged position. The performance of each will ultimately be affected by company-specific news -- potentially in direct opposition to your expectations.

This isn't an effort to put a negative spin on the technique, but understanding the risks involved is essential to successful application of any strategy. It might help if you consider a paired trade as a position in which you need to be right twice to make money, and you have two chances to be wrong and lose.

The first thing to keep in mind when establishing a paired trade: to keep the position balanced, you use a dollar weighting. You don't go by counts of shares or options contracts.

A somewhat extreme example would be pairing Yahoo (NASDAQ:YHOO) against Google (NASDAQ:GOOG). In this case, you would buy (or sell) about 27 shares of Yahoo for every one of Google. In theory, this will mean that if both stocks gain (or fall) 10%, the position's net value will remain constant.

Options Come In

Using options can reduce the risk of a paired trade. I would suggest using fairly long-dated options. This will give your thesis time to play out and reduce the impact of time decay. Let's look at some possible positions and their relative merits.

Buy Calls and Buy Puts

The two main advantages of buying options versus buying and selling the underlying shares include:

1) Reduced margin requirements. The capital required is only the cost of the options which will be significantly less than buying/shorting shares.
2) Limited risk while maintaining unlimited profit potential. This is particularly important on the short side, where short stock positions have unlimited risk, while owning puts carries defined risk.
3) Leverage, which is partially a function of the lower capital requirements, can boost returns on relatively small moves.
4) Flexibility of choosing strike prices to overweight or underweight a position. Again, you still want to start with a dollar weighted approach but shifting strikes or using spreads can help you tailor the risk/reward profile.

The main disadvantage with options in paired trades is time decay. You will need the value spread between the two issues to move substantially in your predicted direction to overcome the erosion of the options' premium. If both stocks stand still over a long period, the position will lose money on both sides of the trade.

For those willing to assume a much higher level of risk, one can take the approach of selling both puts and calls. The initial capital requirements will be nearly equal and the risk is just as great as the stock-only position. But the potential profit is limited to the amount of premium sold.

The main attraction of employing this strategy would be to take advantage of time decay and rich premiums. In this case, it definitely makes sense to use short-dated options and not go too far into the money. Even if both stocks remain unchanged, this position can make money.

Remember, paired trades require one to be right on two stocks, not just one -- but options can expand margin for error and still leave room for unlimited gains.

Let the stock picking begin.

Steve Smith's OptionSmith portfolio was up 43% in 2013. Take a FREE 14 day trial to get exclusive access to the portfolio and trade alerts emailed to you before every trade. Learn more.
POSITION:  No positions in stocks mentioned.