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Pairs Trading
What is pairs trading? There is more than one kind of pairs trading but in this article we will be discussing Stockpair pair options trading. Pair options were first introduced to the retail markets with the official launch of Stockpair in 2010. Since that time pairs trading with options has rapidly gained in popularity and mainstream acceptance by the trading community. A predictable result of this popularity with traders has been the spread of pairs trading beyond just the Stockpair platform. Many of the most popular binary options brokers have incorporated some pairs trading capability into their binary options platforms. However, the pair options offered by these brokers are a bit different from those offered by Stockpair.
Pairs Trading – Pair Options With Stockpair
All varieties of pair options contracts at the various brokers share some fundamental characteristics which make them “pair options,” of course. So before getting to the specifics of each contract type let’s look at a general overview of what these instruments are all about.
Pairs trading is the simplest means of trading on the relative performance of a “pair” of underlying assets. Most often the “paired” assets will be similar or from the same sector. And, because it is only the relative performance that matters, pairs trading is a completely market neutral form of trading. Simply meaning that overall market conditions are irrelevant to the outcome of your trades. You can make money on up or down markets with equal ease, it makes no difference. That’s pairs trading in a nutshell, but don’t worry we’ll be going a bit deeper than that. But first some highlights…
- Entirely Market Neutral Instruments
- High Returns Of Up To 350% Per Trade
- Precise Risk Management
- Extremely Simple To Learn & Trade
- Great For Hedging Other Instruments
- Simple “Standard Deviation” Pairs Trading Strategies
- Smaller Than Usual Drawdowns
I think that those are probably the main and most important highlights of pair options trading. Certainly there are others, but you will discover them on your own easily enough if you decide to try pairs trading. And some will apply more to one variety of pair options contract than another, so you’ll have to play around a bit. Because they are the simplest form we’ll first go over the type of pairs trading that you will find at brokers that specialize in binary options. That is, everyone besides Stockpair.
Pairs Trading With Binary Options Brokers
The image above was taken from our personal trading accounts at one of the popular US binary options brokers. As you can see from the images, both brokers treat their pair options contracts just like their standard high/low binary options contracts. And this is true across all the brokers that currently offer some pairs trading capability. This is very similar to, but not exactly like the “Fixed” variety of pair options offered by Stockpair. We’ll get to those shortly. This variety is quite simple and they are very similar to a forex trade in most ways. The only major difference is that the assets paired are stocks and commodities instead of currencies.
Stockpair Pairs Trading Examples
Stockpair, as the name implies, specializes in pairs trading. They were the first to bring pair options trading to the retail sector. As such they have a unique and proprietary trading platform that was built around the idea of pair options. They later added binary options as well and are a strong competitor in that area too. Stockpair is the undisputed king of pair options trading and they do it extremely well. Unfortunately, they no longer accept US traders. But they do accept clients from most EU countries.
Fixed Pair Options At Stockpair
As we mentioned earlier, the fixed variety of pair options are very similar to the standard high/low binary option contract. Which is why binary brokers were able to incorporate at least limited pairs trading into their platforms. Nevertheless, Stockpair still does it better and they are a little different, so let’s take a closer look.
Stockpair pair options trading offers more asset variety and features than the pairs trading offered by other binary option brokers. They also offer a much better expiry selection. With ranges from 5 minutes all the way up to 150 days! They generally offer higher return rates on their fixed pairs than the other brokers as well. But not always. With these contracts performance is measured only from the time of purchase forward, until expiry. Let’s look at a quick fixed pairs trading example.
Fixed Pairs Trading Example
To simplify things we’ll use the stocks from the image above for this fixed pairs trading example. Lets say our hypothetical trader believes that Google is likely to perform better than Facebook over the next two weeks. Nothing that has taken place before now matters to our trade. As soon as we purchase our “put” fixed pair option on FB/GOOG their performances are set equal to each other.
1) Purchase of Put Fixed Pair Option for $100 on FB/GOOG pair
2) Fixed Pair Offering Returns of 84%
3) Performances Are Reset By Stockpair To Equal 0.00%
Now let us further assume that our hypothetical trader was correct. After announcing a positive earnings beat after markets close on Friday, Google stock soars during Monday’s trading. Fast forwarding to the end of our two-week expiry window we have the following results.
1) Facebook Stock Has Gained 1.73% From Time of Purchase to Expiry
2) Google Stock Has Gained 2.32% From Time of Purchase to Expiry
3) Meaning Google Outperformed Facebook by 0.59% Over the Period
4) Which in Turn Means the Trade Finishes ITM For a $184 Return
Floating Pair Options At Stockpair
Floating pair options are only available at Stockpair as far as we know. This type of pairs trading is the more “exotic” of the two pair options contract types. These instruments can offer returns from just a few percent, all the way on up to over 350%. There is a lot of flexibility and room for pair trading strategies with these contracts. They are what made Stockpair a star originally.
With floating pair options contracts performance is measured over a fixed period of time. They do not reset at the time of purchase. This allows for “floating” return rates that fluctuate with the difference between the two assets performances. Which sounds more complicated than it really is. These contracts are only available with three expiry windows though. They are offered for a day, a week or a month. Performance is measured over the whole of those periods. As a result divergences can grow quite wide.
Floating Pairs Trading Example
Once again we’ll use the trade image above for our example to keep things simple. In this example the expiry window for the floating pairs trade is one day. And this image shows a couple of hours into the day. At this point RIO had performed significantly better so far that day. Therefore RIO had the better chance of finishing the day as the dominant performer. Our hypothetical trader believes that RIO is almost certain to maintain its lead throughout the day. He is happy to take an easy 27% return. Not bad for such a “sure thing.”
1) Prior To Purchase BHP Had Lost 0.73% So Far That Day
2) Prior To Purchase RIO Had Lost 0.26% So Far That Day
3) So RIO Had OutPerformed BHP by +0.47% So Far That Day
For our newly opened trade expiring at the end of the day to finish as a loser BHP would need to outperform RIO by 0.48%. And it would have to happen over the course of the rest of this day. Certainly possible but very unlikely given the circumstances. And in fact our trader was correct. BHP did not rally to overtake RIO in the last half of the day. This trade then finished solidly ITM for a 27% payout. A return of $127 on our $100 investment. Not a huge gain. But also not bad for such a high-probability trade. It is that kind of flexibility that makes these options so useful and fun to trade.
Pair Options Trading Introduction Conclusion
That’s pretty much it for a brief introduction to pairs trading. We will also be publishing some in-depth pair options strategy material in coming months. Stay tuned for that. We have really enjoyed pair options trading ever since we first tried them. This was while doing a review on Stockpair several years ago. Unfortunately, as US traders ourselves we can no longer trade at Stockpair, and our favorite US broker, discussed here in our Raceoption review, unfortunately does not offer Pair Options. But most of the rest of the world is still welcome.
