Trade pair options
By Erik Skyba Senior Quantitative Analyst, TradeStation Labs TSLabs TradeStation. It usually involves a long position in a security that is expected to do well and a short position in a security that is expected to do poorly, both over the same given time horizon. Ideally, at the time of the trade, the long security is undervalued and the short security is overvalued. This valuation is typically based on the type of fundamental analysis done in the hedge fund and mutual fund community. The fascination with market-neutral equity strategies since the early s largely reflects an interest in the possibility of achieving a consistent return while taking on very low levels of risk. As mentioned, traders also like these strategies because they tend to have a very low correlation to the market. In this paper, we focus on the beta-neutral quality of these strategies. In practice, most market-neutral portfolios are designed to be unaffected by overall market returns. This is typically achieved through a dollar-neutral portfolio, beta-neutral portfolio or an optimally weighted portfolio. The dollar-neutral portfolio has no pair equity exposure because of an equal dollar amount invested in longs and shorts, e. A beta-neutral portfolio is constructed so the beta of the long positions equals the beta of the short positions. In effect, the beta of the short positions is cancelling out the beta of the long positions. We pair use the volatility of a security as measured by standard deviation to characterize its movement. For example, in Figure 1, notice that the volatilities for GS and BAC, both in the financial sector, are very different. GS has an annual standard pair of Theoretically, we can say that if positive news for the financial sector hits the newswire, then BAC will have a stronger. If the news is bearish for the financial sector, then BAC is likely to have a much larger negative move than GS. Hence volatility is a very important consideration when determining our long and short position sizes for two reasons. First, it allows us to evaluate the long and short securities on a level playing field. By cancelling out the beta risk of the pair, in effect both positions have the exact same beta risk to the market, which is close to zero. Now, options say that some negative news hits the market. BAC, the long leg, will probably go down more than the short position in GS because it has greater volatility. In effect, the pair lost money not because the valuation model was wrong but because there should have been a larger position in the short GS and a smaller position in the long BAC. Instead of losing money, the pair might have made money or lost less. This leads to the question, "What is beta? By reducing net beta of a position to zero, we are eliminating the influence of the overall market on the securities that we are long and short and in options making these positions market neutral. The formula below describes beta Ba. The covariance is telling us how closely the returns of the security and the market security are deviating from their average returns. We are analyzing how closely the returns of both the long and short securities move together or co-vary with the market options. We often think of beta as how sensitive a security is to market movement. A value for beta greater than 1 means that the security pair more sensitive to market moves and a value less than 1 means that the security is less sensitive to pair moves. The column on the right shows the beta for the XLE. In the column on the left, we can see how some stocks components have higher and lower betas than the XLE. These beta values will be factored into our beta-neutral position-size calculation for each stock. The math for creating a market-neutral position is fairly straightforward. These positions are constructed by calculating the beta of options stock component vs. Trade an example, in Figure 3 below, we see that APA's beta is 1. After adding up both of these beta values, we have 2. We then divide the ETF's beta by the total beta values to get the percentage position weighting for the stock component. Next, we subtract this same percentage weighting value from to calculate the ETF's position weighting. One can either go long on options stock and short the ETF or go long on the ETF and short the stock based on these weightings. Figure 3 Stock Symbol: APA Stock Beta, ETF [XLE] Beta, Beta Total, Stock-Wght, ETF-Wght. There are many factors to consider when implementing a market-neutral pair strategy. One example is the relationship between the long and short securities that trade up the pair. This relationship is important because it has an effect on how co-integrated the beta-adjusted spread of the long and short security is. The concept of co-integration, however, is beyond options scope of this paper. In a sense, the relationship between the ETF and its stock component is based on a relative value play. That is, because a percentage of the ETF is made up of the stock, if the correlation between the ETF and the stock is high, then one might want to look for periods when this relationship breaks down where options beta-adjusted spread has widened to consider long and short trade opportunities using some kind of valuation model. The RadarScreen is set options so the top ten components of each ETF are listed under the ETF they represent, as shown in Figure 4. The user can compare the betas and position sizes for the stock component of the trade ETF to the ETF itself. For example, in Figure 4, we see the stock symbol COP. COP is a component of the XLE Energy sector ETF. The RadarScreen display also shows the following columns of data: Figure 5 shows the "Stock Wght" column, which represents the beta-neutral adjusted position weight for the stock in that row. The "ETF Wght" represents the beta-neutral adjusted position weight for the ETF in this example, XLE. As an example, the trade component in the first row is APA. Its weighting is Figure 5 Beta-Adjusted Position Sizes in Percentage Weightings: Stock APA and ETF XLE. Figure 6 shows the percentage weightings converted to a dollar amount for the stock position and the ETF position. As you can see in Figure 7, this value is an input, called "Total Pair Value. Figure 7 Inputs TotalPairValue: Pair 8 shows the share amount that can be bought or sold short for the stock component and its designated sector ETF. Before risking any capital trading a market-neutral equity strategy, you must first address whether to trade the beta-neutral spread or the dollar-neutral spread. Many mutual and hedge funds that are in pair market-neutral equity space are not beta neutral, but they are dollar neutral. One can go long or short either the ETF or the stock component. If you plot the beta-neutral percentage weighting values, you will find that they are fairly stable over time. However, over a lengthy horizon of, say, one to three months, the position weightings for the long and short pair will change. So you might want to consider dynamic rebalancing on a weekly or monthly basis. There are trade other factors to consider before you start trading. For example, how does one decide on what valuation model technical or fundamental to use to determine which security should be held long and which should be held short? Should both the long and short legs be highly correlated or is it options important for the pair to be co-integrated? In reducing any of these risks, the words "neutral" or "neutralize" are often used because of the act of canceling out the risk component by shorting an opposing security with the same risk-component weighting. As discussed, beta neutral is not the only risk neutrality to consider. The directions for loading the eld and workspace files available with this paper are posted below. All support, education and training services and materials on the TradeStation website are for informational purposes and to help customers learn more about how to use the power of TradeStation software and services. No type of trading or investment advice is being made, given or in any manner provided by any TradeStation affiliate. This material may also discuss in detail how TradeStation is designed to help you develop, test and implement trading strategies. However, TradeStation does not provide or suggest trading strategies. We offer you unique tools to help you design your own strategies and look at how they could have performed in the past. While trade believe this is very valuable information, we caution you that simulated past performance of a trading strategy is no guarantee of its future performance or success. We also do not recommend or solicit the purchase or sale of any particular securities or derivative products. Any symbols referenced are used only for the purposes of the demonstration, as an examplenot a recommendation. Finally, this material may discuss automated electronic order placement and execution. Please note that even though TradeStation has been designed to automate your trading strategies and deliver timely order placement, routing and execution, these things, as well as access to the system itself, may at times be delayed or even fail due to market volatility, quote delays, system and software errors, Internet traffic, outages and other factors. Call a TradeStation Specialist Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. Options trading is not suitable for all investors. Your account application to trade options will be considered and approved or disapproved based on all relevant factors, including your trading experience. View the document titled Characteristics and Risks of Standardized Options. System access and trade placement and execution may be delayed or fail due to market volatility and volume, quote delays, system and software errors, Internet traffic, outages and other factors. Neither the Company, nor any of its associated persons, registered representatives, employees, or affiliates offer investment advice or recommendations. The Company may provide general information to potential and prospective customers for the purposes of making an informed investment decision on their own. All proprietary technology in TradeStation is owned by TradeStation Technologies, Inc. Equities, equities trade, and commodity futures products and services are offered by TradeStation Securities, Inc. Skip to main content Skip to main navigation. TradeStation TradingApp Store Developer Center Institutional Services. Chatting With A TradeStation Representative. To help us serve you better, please tell us what we can assist you with today:. If you have questions about a new account or the products we offer, please provide some information before we begin your chat. If you are a client, please log in first. Education TradeStation Labs Analysis Concepts Market-Neutral Pairs Trading. Morning Market Briefing Analysis Concepts Traders Interviews Events. Related Files View Video. Figure 1 Bottom Indicator Shows the Standard Deviations for GS and BAC. Figure 2 Betas for the Top Ten Components of the XLE. Figure 4 RadarScreen Workspace Display Example. Figure 6 Beta-Adjusted Position Sizes in Dollar Terms: Figure 8 Beta-Adjusted Position Sizes in Shares: Stock Components and ETF XLE. Check the background of TradeStation Securities, Inc. Sitemap Contact Us About Us FAQ Terms of Use Security Pair Privacy Policy Customer Agreements Other Information Careers.
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