Chris Rowe

How to Profit Like a Hedge Fund

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Pairs Trading With ETFs

Now let's make it interesting. Let's say you read my Jan. 3, 2008 article titled "Crude Oil Hits $100! 3 Ways to Profit From It!" and you gathered from that read that you could profit from an advance in the energy sector and a decline in the airline sector.

So you took my advice and took a bullish position on the ETF representing energy stocks, the Energy Select Sector SPDR (XLE), and a bearish position on the airline index, the NYSE Arca Airline Index (XAL). Since XAL is an index (not an ETF), you would buy put options on it.

If you used pairs trading and committed the same dollar amount to each of the positions, you would have made a killing, and you would have been hedged.

By the stock market's March 2008 low, the energy ETF that we were bullish on was down 10%, and the airline index that we were bearish on was down 30% (which means a 30% gain). The combined positions show a net gain of 10%.

$10,000 bullish in XLE was down $1,000 (10%)
$10,000 bearish in XAL was up $3,000 (30%)
Net gain on $20,000 is $2,000 (10%)

At the same time, the S&P 500 had declined by 12%.

My Spin on Pairs Trading

My spin on pairs trading is simple. Trading deep in-the-money options (high delta options) in replacement of stock gives you an even better reward-to-risk ratio.

Here's a hypothetical example:

If XYZ stock trades up 10 points, the deep in-the-money (high delta) call option may trade up 9 points.

If XYZ stock trades down 10 points, the deep in-the-money (high delta) call option may only trade down 7 points.

What does that tell you?

First, consider what happens in pairs trading when the bullish stock gains 10% and the bearish position loses 10%. You would be flat, right?

Well, if you replaced your bullish stock position with high delta calls, and your bearish position with high delta puts, here's what happens in the hypothetical example above:

Your call option (assuming it's on a $100 stock) gains 9 points.
Your put option (assuming it's on a $100 stock) loses 7 points.

That's a net gain! Sure it's only 1% in this simple example, but it can be magnified in many circumstances.

Chris Rowe is the Chief Investment Officer for Tycoon Publishing's The Trend Rider. To learn more about him, read his bio.