Trading Pair Options

Trading pair options allows you to speculate on the relative performance between 2 different assets. It is a nice way to trade when you consider the tendency of some markets, such as stocks in the same sector to converge in performance over time. Generally, pairs trading can offer you a smoother trend, less wild volatility, and fewer surprises; in some cases it can even offer you very low risk and all the reward. Above all, it offers you a way to stay protected from the stock market's own major trend, at times of uncertainty and high risk.

As you can see on the weekly chart below, 2 stocks, Ford and GM are being compared; the blue line is their relative performance. The chart indicates the middle point with a gray line, this is the point of maximum convergence, and 2 levels of usual divergence, where the relative performance diverges the most then reverts to the convergence middle line or may diverge further out first. The first level of maximum divergence is named First Standard Deviation and is marked in yellow. The next usual and higher divergence level is named Second Standard Deviation and is marked in red. Basically all you have to do is buy the extreme bottoms and sell the extreme tops, or even buy and sell at the bottom and top yellow lines respectively. The probability of the trade yielding a profit is quite high, as long as you get the timing right.

Another way to process stock data, is to get daily closing prices for the stocks in question, in Excel compatible format, put the daily closes on different columns for each stock, then use the formula ((Today's close / Previous Close) -1) x 100 and drag it along each column of data. What you will get is positive and negative daily closes in percentage form, you can then plot these 2 columns of the 2 different stocks, and you will end up with a chart showing vector-like straight lines. These lines meet at convergence, and diverge very clearly, in a very visual way at maximum divergence allowing you to figure out right away historical maximum divergence points, as well as more frequent divergence points.

What an Excel relative daily performance chart looks like:

Suppose that the above charts depicts the relative performance of 2 stocks, say stock Red and stock Blue. Their performance seems to diverge a lot at point 6 and point 9 on the horizontal axis. This is where you can clearly see that at point 6, the Blue stock is outperforming the Red stock therefore you choose a binary option, say the binary option instrument (Blue stock OVER Red stock) and you buy the PUT option of this binary option instrument since you expect it to lessen in value, and indeed a little while later, the 2 stocks start to converge, and finally completely converge at point 8.

At divergence point 9 however, our hypothetical trade has to be reversed, since stock Blue is the under performer, therefore you pick the (Blue stock OVER Red stock) binary instrument again, but this time you expect it to increase in value (as the blue line will converge with the red). Therefore you buy the Call option this time. And again the lines converge later at point 10, and you can exit at a profit.

It takes a little work with Excel to plot and figure out typical divergences, but this will enable you to be well prepared, and know when to trade these pair options. In addition to the typical divergences also bear in mind that oftentimes bad news can cause one of the stocks in the pair to drop too much. In this case remember that the stock will most likely recover, so you have to trade it the usual way. The Excel charting technique can tell you where exactly you should get out so there's no point holding the trade any longer than necessary. It is like the middle gray line on the more conventional chart, but much easier to understand, as you get to visually see the gaps in relative performance.

Trading pairs offers great opportunities and smooth trading action. Just make sure you pick stocks that are in safe market sectors, ideally stocks such as oil stocks, or stocks in the utilities sector, not high tech stocks. It's much safer this way.

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