A paired trade is something like betting the exacta in a horse race -- profitability requires accurately predicting the performance of two similar but entirely independent entities. Unfortunately, both are widely misunderstood and often misused strategies.

The most common mistake in exacta wagering is reversing combinations or even creating a three-horse "box" (sounds like option trading already) in the belief that covering more possible outcomes will improve the odds of winning. What isn't usually considered is that you're also increasing the number of bets guaranteed to lose and therefore greatly diminishing your potential return.

Similarly, the concept that a paired trade is a hedged position can give investors a false sense of comfort because it doesn't accurately convey the risk involved. In taking two positions, you've more than doubled the number of scenarios that could result in loss. There is the possibility for an unlimited loss because the long position could stand still, or even go to zero, while the short position could theoretically rise to infinity.

Astute investors are always trying to minimize losing scenarios and increase winning ones. Using options to create a paired trade can provide a distinct advantage over a pairing of the underlying security by turning a potential losing scenario into a modest gain.

If you'll allow me to beat the horse analogy to death, it's understood the horses and companies are competing in the same environment -- a muddy track or a weakening economy might hurt the group's overall results, but individual performances vary widely and are rarely affected by the actions of other participants. Losing by 20 lengths in a fast race is no better than losing by 20 lengths in a slow race.

Using Options to Keep Pace

While closing the performance gap is the objective when pairing up equities (assuming one is long the cheaper stock and short the higher-priced), an options pair may be profitable even if the spread between two stocks merely keeps pace or even widens.

Let's say I'm going to buy Hilton ( HLT) calls and short Starwood Hotels ( HOT) calls. Let's tick through the reasons: At $13, Hilton is trading at 23 times earnings, has operating margins of 21.5% and should manage a modest increase in earnings per share.

By comparison, Starwood's current price of $28 reflects a multiple of 40 times current earnings, has operating margins of 14% and is experiencing negative earnings growth. In addition, Starwood has been selling properties -- particularly in Asia -- to reduce debt, and the growth from its W line of boutique hotels is both disappointing and waning.

On Tuesday, with Hilton at $13, you could buy the $15 January 2004 call for 50 cents. At the same time, with Starwood trading at $28, you could sell its $30 January 2004 call at $2, resulting in a net credit of $1.50 per paired call position.

The profit-and-loss profile of the options position for any scenarios involving rising prices (while the spread narrows, widens or stays the same) is comparable to a pairing of the underlying equities. The variance will range from a plus $1.50 to a negative 50 cents (which is a good trade-off in itself) no matter how high the stock prices rise.

But in unchanged or declining price scenarios, options offer a distinct edge. Assume the stock prices either don't change or fall between now and expiration; both call options would expire out of the money and become worthless. This would result in a gross profit of $150 (the amount of premium collected) per paired call. This holds true even if Hilton declines more than Starwood and the spread between the two widens.

For example, if Hilton should fall to $8 and Starwood drop to $26, the spread widens from $15 to $18. The option position would still yield the $150 profit per pair while the paired equities would incur a loss of $300 per 100 shares paired. Using options to turn potential losing scenarios into winners is an edge that traders shouldn't ignore.

While the basis for matching a pair should always rest on some fundamental reasoning, because "closing the gap" is where the real profit is achieved, adding some option-based criteria will provide a risk cushion in case the thesis doesn't work. You should pay particular attention to disparity in absolute price, valuation and volatility.

Another advantage of pairing options vs. the underlying security is that by using different strike or expiration periods, you can emphasize a particular metric that aligns with specific goals. For example, using shorter-dated options would emphasize the theta, or time decay, of the position rather than the fundamentals, while shorting a deeper-in-the-money call (like Starwood in the example) would emphasize a narrowing of the spread.

The ability to shift the odds ever so slightly and generate incremental income -- even when things don't necessarily work as planned -- is the bedrock of long-term profitable trading.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to Steve Smith.

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