Volatility pairs trading

Unlocking Hidden Opportunities: Volatility Pairs Trading

By:Kai Zeng

This strategy can reduce directional risk and achieve a more stable portfolio

Pairs trading is a widely used strategy to manage risk in a portfolio by simultaneously buying and selling two assets that have a positive correlation, such as the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA). The goal of this approach is to capitalize on the potential for SPY to increase in value while minimizing the potential downside risk if SPY were to decline. By implementing this strategy, traders can reduce directional risk and achieve a more stable portfolio.

12-month correlation of prices

This concept can also be applied to options trading strategies. Known as options pairs trading, it is a slightly more complex approach that incorporates the use of options. This method differs from equities trading as it takes into account another factor—implied volatility. By selling the higher implied volatility of SPY and purchasing the lower implied volatility of DIA, traders can create a strategy aimed at not only reducing directional risk but also at stabilizing portfolio volatility. This was the original intention behind this approach.

The strategic interplay between SPY and DIA is fascinating. With SPY typically exhibiting higher implied volatility, there's potential for a volatility pairs strategy.

Exploring Volatility Pairs Trade

So we at the tastylive research team tested the following strategy: We sold 1SD (one standard deviation) strangles on SPY while simultaneously buying equivalent delta strangles on DIA. These positions are often held until expiration, with adjustments made at the 21-day mark to optimize performance.

By pairing the volatility of these two indices, traders have experienced better control over losses and overall volatility compared to solely trading SPY strangles. It's essential to recognize that this strategy might not always maximize returns because of modest return on capital and the need for higher buying power.

strangle pairs and SPY strangle

The insight gained from managing these positions suggests there are enhancements across the board. By adjusting both strategies at the 21-day mark, traders can refine their approach and potentially improve outcomes.

21 DTE strangle pairs

For traders looking to venture into pairs trading with options, it's a strategic move that can help minimize directional risk and manage volatility in your portfolio. However, it's crucial to approach this strategy with caution. While the volatility pairs trade strategy can be a prudent way to trade, it's not always the most profitable because of its lower potential for return and the requirement for substantial buying power.

Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1 

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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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