Pair trading strategies are usually statistical in nature as the investor is looking to take advantage of highly correlated stocks that generally trade in tandem. The trick in using a statistical arbitrage strategy is to find a point where an anomaly is generated, and look for the long term relationship to return to normal.
These types of strategies are known as market neutral and have historically been implemented by financial institutions. Instead of waiting for a stock or commodity to reach as specific price point, you are monitoring the relationship between two financial instruments, and finding a point where the correlation breaks down and the divergence of returns creates a trading opportunity.
One of the best strategies for pair options trading is to look at movements of the ratio, (one asset divided by the other), and find a distribution where the current ratio is beyond 2 or 3 standard deviations for the medium term moving average.
In a way, this process resemble a Bollinger band strategy, but using the ratio of one stock to another. This type of mean reversion strategy generally works when there has not been a permanent change in the business of a company. Situations such as bankruptcy, will permanently change the relationship between to stocks.
Options on stock pairs have recently been introduced. These products allow an investor to either receive a fixed payout over a day, week or month where the returns are binary in nature. In essence, the product is a binary option on a spread of two financial instruments. The payout of 85%, is available on a risk of 100% of the capital on the trade. That means an investor needs to win 55% of the time to create a profitable strategy. Mean reversion trades are generally produced less thenÂ directional trades, but the win to loss ratio is relatively high.
Another type of trade offered as an option of a pair is a floating option. This payout is daily, weekly or monthly, and measures relative performance for the entire floating period. A daily would start at 9am (or listed time) and end at 4pm (check listed time). It is not measured from the entry point of the trade. Instead the broker provides a percentage return which is the value of owning the trade from that point to the end of the period. The benefit of floating trades, is that there can be a take profit before the end of the trading period.
Pair options trading is similar to pair trading, in that similar strategies can be use to take advantage of a market that has sound statistical strategies.