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Pairing Up for Profit

But beware, the assumption that there is a level of price correlation between the two equities often leads investors to have 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 is not a hedged position.

This is not 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.

Options Can Eliminate Ways to Go Wrong

In some situations, using options can reduce the risk of a paired trade, and of course it can complicate matters in others. But in most cases, 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 and short call options: The capital requirements will be moderately lower than the all-stock position, as the long call requires only its initial cost. The long call's downside risk is also limited to that initial cost, thereby somewhat reducing one of the two ways you can be wrong.

The disadvantage is that the short call will provide only limited downside protection. It might make sense to use only slightly in-the-money or at-the-money calls to reduce your cost and risk, but the use of short calls that are deeper in the money will help you gain more downside protection. You can play with the numbers and find ratios and dollar amounts to find one that fits your expectations and risk threshold. This type of position can, of course, also be established using puts.

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