-- A.M. Sure, options can be used to set up a paired trade. Before getting to some possible constructions, a couple of quick words on paired trades. In a typical paired stock trade, one simultaneously takes a long position in one stock and a short position in another of companies that are considered competitors. The idea is that the shares of one will outperform the shares of the other. Most paired positions are based on fundamental analysis in which valuation or prospects of one company look more attractive when compared to another. An example might be buying Yahoo! ( YHOO) and selling Google ( GOOG), or vice versa. One basic thing to keep in mind when establishing a paired trade is that to keep the position balanced, you can use a dollar weighting, not an equal number of shares. So in the Yahoo!-Google example, you would buy (or sell) about six shares of the former for every one of the latter. In theory, this will mean that if both stocks gain (or fall) 10%, the position's net value will remain constant. Here's a caveat: 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. Be warned that a paired trade is not a hedged position. This is not putting a negative spin on the technique, but for safety's sake you might do well to think of 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. Using options can actually complicate the situation, but in some situations it can also reduce the risk. 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 calls and short call options. The capital requirements will be moderately lower than the all-stock position, as the long call only requires its initial cost. The long call also has downside risk limited to that initial cost, thereby somewhat reducing one of the two ways you can be wrong.
Price vs. Implied Volatility: Which Comes First?You bring up lots of issues that keep me going back to the books. In the
Options with weeks or even months until expiration can see their implied volatility -- and therefore their value -- get pumped up ahead of the price-moving event, then quickly dissipate once the news is out...Can you explain how implied volatility gets pumped up? I thought that I.V. followed the premium. So, in your example, the market makers would be bumping up the premium in anticipation of news, which bumps the I.V. Thanks,
San Diego An option's value, or the premium it is awarded, is intimately tied to the level of its implied volatility. This can often lead to circular logic, such as believing that the price went up because implied volatility went up. My statement above may have blurred the cause-and-effect relationship between the two; let's try to clarify. Implied volatility is one of the five inputs used by the