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Pairs Trading Price Volatility

Best Practices

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

One of the things we firmly believe in at tastytrade is the importance of staying engaged in the markets so our Market Awareness remains well tuned. When Implied Volatility (IV) and IV Rank (IVR) are as low as they are now it is difficult to sell option premium. One way we can stay engaged in the markets and hopefully take on less risk than trading an outright position is to place a Pairs Trade. So what exactly is a Pairs Trade, how is it done and what do we have to know?

We look for correlated underlyings that have had a price relationship and which although they have moved outside that price relationship we expect that they will return, at least somewhat, to it. Typically, this will happen if one stock gains or loses in price significantly more than the other.

Pairs trading involves the trading of correlated underlyings which seem to have moved outside some recent price relationship. This is especially true after the underlyings have moved contrary to their typical relationship or if one stock is particularly overextended compared to the other. A table of the correlation between KO (Coca-Cola), PEP (PepsiCo), GLD (Gold ETF), TLT (Bond ETF) and SPY (S&P 500 ETF) was displayed. The table showed that KO and PEP had a high correlation of 0.82. A graph showed that recently the price PEP is up 6% while KO is down 2%.

We are looking at this pair of stocks in terms of percentage moves. That means to trade them we need to think in terms of notional value. An example of a pairs trade between KO and PEP was displayed. The table included the current price, the position, the Delta and the notional value. The table showed how to match the notional amount of the 2 underlyings by adjusting for Delta. Additionally, we can also look at divergences in IV. PEP generally trades with a higher IV than KO. A reversal of this relationship would create an opportunity. We might short puts in KO and buy them in PEP to trade not only a divergence in price but also IV.

For more information on Pairs Trading see:

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of the value of Pairs Trading as a way to reduce your risk and stay engaged in a low IV environment.

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