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.
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.