Managing pairs trading within the POWR Options way will likely increase the likelihood of profit.
We have discussed the advantages of the pairs trading approach in several previous articles. Pairs trading is just taking a bullish position on a stock that you’re thinking that will outperform similar stocks that you simply take a bearish position on. Buy Ford/Sell General Motors classic example in case you think Ford will probably be higher than GM.
Instead of using easy actions to specific points of view, in some ways it is healthier to make use of options. Why? Reduced risk, lower upfront costs, and three lesser-known but very vital advantages.
A fast review of our recent trades within the POWR options portfolio will help shed some light on understanding these “invisible” trade management advantages we employ.
The pair trade we selected was a recently accomplished bullish buy on Cheniere Energy Partners (CQP) and a bearish buy on Sunoco (SUN). Both oil-related names are so highly correlated with stocks, meaning they often move up and down together.
Initial trade on February 27 shown below:
Action to take
Action to take
It did occur, but to not an excellent extent. The spread converged by around 3.5%, narrowing from 17.7% to 14.15% as each stocks fell sharply.
However, our pairs traded quite well. Closed on March 15 as seen below.
We gained $490 on SUN put options and lost only $290 on CQP options for a net profit of $200 as shown within the table.
The initial cost of trading the pairs was $810. A net profit of $200 corresponds to a return of 24.69%. The detention period was just over two weeks. Also, in the beginning of the trade, we were protected by a bullish call and a bearish stance on two highly correlated stocks.
So while the 2 stocks that involved the pair trading began to converge as expected, that convergence definitely didn’t account for many of the gain.
Instead, the three things listed below – gamma, time decay management and implied volatility evaluation – are the hidden advantages of the POWR Options Pairs Trade approach.
Gamma
The options move in a curved fashion, not a linear one. The greater the favorable move within the underlying stock, the more favorable the choice moves as compared. Conversely, the greater the unfavorable move within the stock market, the less options will move against you.
The initial delta at the beginning of trading will change because the stock price changes. This rate of change of the choice delta relative to the stock price is named “gamma”.
Gamma is an option measure that describes the speed of change of the choice delta per one-point movement in the worth of the underlying asset. Delta determines how much the premium (price) of the choice changes when the worth of the underlying asset changes by one point.
Buying options gives you an extended gamma. This means you are more right in case you’re right in regards to the dialing direction. It also means you are less fallacious if you’re fallacious about direction. Sounds too good to be true? Well, it’s form of like that because timing is the bad part about buying options.
The decay of time
Options are a wasted asset. With each passing day, they lose somewhat more of their overall value. This concept is named time decay, or theta, to make use of the Greek term. While gamma is the nice side of shopping for options, theta is clearly the bad side. POWR Options is well aware of the passage of time. This is why we almost at all times decide to exit options well before they expire (normally around 30 days).
The image below shows how option time decay really hits hard within the last 30 days before the choice expires. Exiting early and reclaiming the time premium or remaining option value is critical to long-term success.
Certainly, the exit from trading of the CQP/SUN pairs in only a number of weeks made the time fall less relevant.
Having purchased options expiring worthless or for zero value is something that needs to be avoided – in any respect costs. So far we’ve got achieved this at POWR Options.
Implied volatility
At POWR Options, we at all times keep an in depth eye on Implied Volatility (IV) when considering trading opportunities. In our opinion, that is one of the crucial vital elements of options trading.
Implied volatility is a measure of how much the choices market expects the underlying stock to maneuver. Higher IV means greater expected moves and lower IV means smaller expected moves. IV can also be essentially the worth of the choice. The next IV makes options costlier. A lower IV lowers option prices.
Since we at all times buy options, we deal with buying those options which have a comparatively low implied volatility. A low comparative IV means options prices are a bit low-cost – at all times thing.
The current 4th percentile is where the implied volatility is now in comparison with the 4th range over the past 12 months. The lower the percentile, the lower the IV is now. 100% would mean IV is at its highest readings last 12 months. 0% can be the bottom. 50% is about average.
We try to purchase options which are trading well below the 50% mark, in other words, relatively low-cost options. A have a look at each the SUN and CQP options below shows that each were well below the 50% IV percentile after we bought them on Feb 27.
CQP IV
THE SUN IV
Below you may see how the implied volatility (IV) jumped from 20.85% after we bought the SUN positions to over 36% after we closed the position. Another advantage of shopping for low-cost options or low IV options. It can also be shown that the delta in these bearish positions has moved from -65 to -80 which is a positive gamma effect.
The same scenario also played out within the CQP calls.
The strength of the POWR rankings plus the expected convergence of related stocks generally is a definite advantage when constructing par trades. Understanding the somewhat hidden advantages of gamma, time decay management, and implied volatility evaluation turns pair trades into POWR Pairs trades. With this approach, you’ll increase the chances in your favor.
RETURN Options
What to do next?
If you’re in search of the most effective options trading in today’s market, it’s best to try our latest presentation How to trade options with POWR rankings. Here we show you find out how to consistently find the most effective options trades while minimizing your risk.
If this appeals to you and you ought to know more about this powerful latest option strategy, click below to access the present investment presentation:
How to trade options with POWR rankings
Tim Biggam
SUN shares closed at $41.60 on Friday, down -$0.32 (-0.76%). Year-to-date, the SUN is down -1.79%, in comparison with the S&P 500 index’s 1.98% gain over the identical period.
About the Author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Chief Options Strategist at ThinkorSwim and three years as Market Maker for First Options in Chicago. He appears often on Bloomberg TV and is a weekly contributor to the TD Ameritrade network “Morning Trade Live”. His overriding passion is to make the complex world of options more comprehensible and subsequently more useful to the on a regular basis trader. Tim is the editor RETURN Options Bulletin. Find out more about Tim’s past with links to his latest articles.
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