You are on page 1of 111

1

PAIRS TRADING
THE FINAL FRONTIER
2
Risk Disclosure
We Are Not Financial Advisors or a Broker/Dealer: Neither TheoTrade nor any of its ocers, employees,
representaAves, agents, or independent contractors are, in such capaciAes, licensed nancial advisors, registered
investment advisers, or registered broker-dealers. TheoTrade does not provide investment or nancial advice or make
investment recommendaAons, nor is it in the business of transacAng trades, nor does it direct client commodity accounts
or give commodity trading advice tailored to any parAcular clients situaAon. Nothing contained in this communicaAon
consAtutes a solicitaAon, recommendaAon, promoAon, endorsement, or oer by TheoTrade of any parAcular security,
transacAon, or investment.
SecuriAes Used as Examples: The security used in this example is used for illustraAve purposes only. TheoTrade is
not recommending that you buy or sell this security. Past performance shown in examples may not be indicaAve of future
performance.
Return on Investment ROI Examples: The security used in this example is for illustraAve purposes only. The
calculaAon used to determine the return on investment ROI does not include the number of trades, commissions, or any
other factors used to determine ROI. The ROI calculaAon measures the protability of investment and, as such, there are
alternate methods to calculate/express it. All informaAon provided are for educaAonal purposes only and does not imply,
express, or guarantee future returns. Past performance shown in examples may not be indicaAve of future performance.
InvesAng Risk: Trading securiAes can involve high risk and the loss of any funds invested. Investment informaAon
provided may not be appropriate for all investors and is provided without respect to individual investor nancial
sophisAcaAon, nancial situaAon, invesAng Ame horizon, or risk tolerance.
OpAons Trading Risk: OpAons trading is generally more complex than stock trading and may not be suitable for some
investors. GranAng opAons and some other opAons strategies can result in the loss of more than the original amount
invested. Before trading opAons, a person should review the document CharacterisAcs and Risks of Standardized OpAons,
available from your broker or any exchange on which opAons are traded.
No part of this presentaAon may be copied, recorded, or rebroadcast in any form without the prior wriXen consent
of TheoTrade .
No SoliciAng. No Recording. No Photography.
Don Kaufman
Co-Founder TheoTrade

Industry-leading options strategist

Derivatives Risk Manager

18 year trading career

16 years of thinkorswim platform experience

3
4

Learning Objectives
Introduction to Pairs Trading
Discover and Build Correlation Charts and Trades
Learn Entry and Exit Criteria for Pairs Trades
Aligning Pairs Trades
Executing Trades Upon Divergences and Statistical
Opportunities
High Probability Split Irons
Converting Pairs Trades for Options and Futures Execution
5

INTRODUCTION TO PAIRS TRADING


Discovering my pair
6

Forget everything (about the markets)


Pairs trading takes a different approach to the markets by
means of looking at correlations, divergences, and statistical
data in attempt to capitalize.
7

Direction can help you no more


Traders and investors alike are classically trained in attempt to distinguish what
the markets next move could be.
Financial media, trading technology, and nearly everything regarding markets is
about directional bias.
Direction of the markets and stocks means nothing from here on out.
We are all about relationships.. (market relationships, this is not Tinder)
8

Basic skills redefined


There are 3 basic concepts youll need to understand..
1. What a stock is
2. How to buy a stock aka long position
3. How to sell a stock short aka short position
9

Pairs trading defined


Pairs trades are market-neutral, meaning the overall direction
of the market does not significantly affect the overall
profitability and or loss of a given trade.
10

Pairs Trading Clarified


When I first got involved in Pairs Trading it was statistical
arbitrage; yep total trader geek stuff but the concept is
identical for retail traders.

What do you like more Coke or Pepsi?


Whatever you answer happens to beyou can build a trade around it
11

Coke versus Pepsi


I grew up drinking COKE, Pepsi people where not allowed in
my house

Therefore, we Buy COKE and Sell PEPSI

KO vs PEP the epic battle of good vs evil

How would this have played out over the past 5 years?
12

Battle of Good vs Evil aka: Coke vs Pepsi


13

Basics of Pairs Trades


The goal is to match two trading vehicles that are highly
correlated. An example of this could be two stocks in the
same sector or with similar business interests.

But why consider trading two stocks in the same sector?


Would this not increase your risk?

You are looking to create one LONG position and one SHORT
position
14

Pairs Logic
The Pairs logic is to seek out correlated stocks, indices, or
products currently displaying a divergence.

You are looking to create one LONG position and one SHORT
position, the PAIR offsets risk in one another.

You are seeking the deeply correlated Pair to


normalize (mean reversion) whereby coming back into
alignment.
15

Profit and Loss


Where do you achieve profit and or loss on PAIRS TRADES?
As the pairs convergences or divergences profits and losses are
realized

Here are a few examples of where profit can be realized:


If your long product appreciates (goes up) and the short product stays
relatively flat you profit.
If your short product moves down and the long product moves down less
than the short you profit.
The long product can rally and the short product can fall.
Markets can crash and burn you just hope your short product burns down
faster.
16

How do You Profit and Loss continued


In the aforementioned example, how can you profit (or lose) from the comparison
of Coke versus Pepsi.
Assume you BUY Coke and Sell Pepsi, profit scenarios:
1. Pepsi could sell-off with Coke staying relatively flat.
2. Coke could rally with Pepsi staying relatively flat.
3. Coke could rally and Pepsi could sell-off.
4. Coke could sell-off and Pepsi could sell-off at a faster rate.
17

Advanced Pairs Example


XLE (energy sector ETF) and Exxon are an ETF and a
component of the ETF and tend to move in relative tandem.

Do opportunities exist to trade these etfs/stocks against one


another?
18

Divergences Exist
19

Correlations Ebb and Flow


20

Ebb and Flow of pairs trades


Divergence - When the price of an asset and an indicator,
index or other related asset move in opposite directions

Convergence - indicated by the Pair reverting to the mean


(coming back into alignment).
21

Structure of the Pairs trade


The PAIRS TRADE is structured via being long on security and
short the other.
In our XLE versus XOM pairing we are looking to short XLE
and go long XOM.
22

Structure of the Pairs trade continued


Do NOT get too excited this is not as easy as short XLE and buy
XOM.

XLE is a $72.77 ETF

XOM is a $83.40 stock

Pairs trading is about how to covert and trade one product versus
another and we will detail precisely how to associate the shares
of 2 products.
23

Advantages of Pairs Trading


The pairs trade helps control market risk.
If the market or sector crashes the short position negates the
loss of the long position.
Trading strategies independent of market movements are
said to be Market Neutral.
24

Drawbacks of pairs trading


Equities can diverge due to news, earnings, takeovers etc.
Increased transaction costs with a more active strategy (trading
less can help).
Poor selection of your Pair or breakdown of the correlation.

If the proverbial hits the fan you better make sure your
correlation holds up. Just take a look back at 2008 and see how
a Pairs Trade may have played out. If you follow our steps your
risk will be relatively controlled in these trades.
25

Using Alternative Products


As a reminder we will cover how to trade Pairs in Options and
with Futures contracts.

The logic of Pairs Trades is identical with alternative products,


nothing more than a conversion (or strategy with options) is
necessary.
26

Leaving it all behind


Please attempt during this class to leave technical analysis
out of the equation.

Technical analysis can be viable in some instances of Pairs


Trading however, we will focus exclusively on statistical data,
comparative analysis, and correlations.
27

Pray for Volatility


Heavier Volatility produces more opportunities in Pairs
Trading as divergences of correlated products ensue in higher
frequency.

With heavier volatility you need LESS capital however, you will
have more exposure to risk due to Pairs decoupling.
28

Finding pairs candidates


Competing companies possibly in similar sectors.
Correlation scanning and analysis
ETF and or Index related products often see high correlations.

We will dig deeply into Pairs trade setups and candidates, Im


going to provide you with some specific Pairs whereby you
can get started without inordinate risk.
29

CONSTRUCTING YOUR PAIRS TRADE


Build it, and they shall converge
30

How do you find Pairs Candidates?


Allow me to introduce to you a few major concepts used in Pairs
Trading.

You might understand the general idea or gist of the Pairs trade
but now lets go through a number of specifics in order for you to
be confident in finding your own candidates.

We are about to run through individual steps placed in checklist


format for faster accessibility to building viable Pairs Trades.

DO NOT SKIP STEPS !


31

Entry and exit criteria


Youre about to get ALL the criteria for Pairs Trading.

Please do not freak out, we will walk through EVERY step multiple
times and stop along the way to provide infinite detail.

Its necessary to provide a clear road map prior to driving down


the road!

Google maps does it you should too!


32

Criteria for Pairs trading


1. Building a comparison chart
2. Finding a high correlaAon in two products, ETFs or products in the same
sector
3. IdenAfying visual divergence between highly correlated products
4. Check your Pair in MULITPLE Ame frames, 3 months, 6 months, 9 months
5. Select a Ame frame you intend to trade the Pair, days, weeks, months.
6. Pairs Standard DeviaAon Study at or near a 2 standard deviaAon move.
7. Check the historical volaAlity of EACH individual product does NOT
exceed a 20% dierenAal.
8. Alignment of the Pairs Trade number of shares to trade of each
product.
9. ExecuAon of the Pairs Trade
10. Prot and Loss risk and reward of your pair
11. Segng Alerts
12. Exit criteria
33

1. Building a Comparison Chart


Lets learn to build a Comparison Chart and understand what
studies can help you understand your Pair :

Compare one product versus another product.


But how do you compare a $100 stock with a $30 dollar ETF?
Comparison charts can be done on a percentage basis or
using a left and right axis chart (more advanced).
In comparison charts, ALWAYS use LINE CHARTS, never
candlesticks.
34

Comparison Chart
35

2. Finding a high correlation in two products


Correlation coefficient
Next you add the correlation coefficient.
Sounds fancy but this is just to make sure the products you
are using are in fact highly correlated.
36

Understanding Correlation
Correlation is the statistical measure of how two securities
move in relation to each other.
Correlation is computed into what is known as the correlation
coefficient, which ranges between -1 and +1.
There are positive correlations and negative correlations.
NEGATIVE correlation indicates a security is moving in precisely the
opposite of the primary products.
POSITIVE correlation indicates a security if moving in the same
direction or in tandem with the primary product.
37

Correlation Coefficient
Look for heavy correlations in some instances EXCEEDING
80%

The breakdown of correlation helps create opportunity but


you want to make sure your Pair is heavily correlated.
38

Correlation Consistency
Again you are seeking correlations over 80%.

You MUST check in multiple time frames in order to clarify the


2 products are in fact displaying a correlation over 80% of the
time.

For example, look at 3, 6, and 9 month charts with


correlations averaging 80% plus over all 3 periods. (Details to
follow)
39

Comparison with Correlation


40

3. Identifying Visual Divergence


Visual Divergence is where highly correlated products spread
apart and create the possibility and opportunity for a pairs
trade.

Visual Divergence can be the single most powerful tool in


finding viable pairs candidates.

Lets re-examine our XLE versus XOM Pair example to see if


the two have recently diverged.
41

Visual Divergence?
42

4. Multiple time frames


Check if your Pair is heavily correlated in 3 separate time frames.

For example, you intend to trade a Pair with a trade time horizon of 3 months.

Check 3 month, 6 month, and 9 month charts of the Comparison Pair with the
correlation study in order to substantiate your trade will stay correlated over
time.

Pairs look VERY different given a change in time frame, examine your Pair.

If trading for shorter duration use similar methodology, 3 weeks, 6 weeks, and
9 weeks, etc.
43

XLE vs XOM 3 month


44

XLE vs XOM 6 month


45

XLE vs XOM 9 month


46

Stop! Check Your Divergence


The single most powerful tool in finding pairs candidates is
looking for two highly correlated products suddenly diverging
from one another.
The key is to recognize a chart with a 3 month time frame
displaying a divergence may look vastly different from a 6
month chart whereby you may realize the pair is NOT in fact
diverging.
Check multiple time frames, it MATTERS!
47

5. Select a pairs trade Time Frame


Intra-day, monthly or even long duration pairs trades are
viable. Depending upon your available capital, trading ability,
and allocation of time you can choose the applicable time
frame.

Do NOT consider short duration (intra-day) Pairs Trades


without considerable experience.

There is less edge in the intra-day trades and your execution


of the strategy needs to be at a high level.
48

6. Pairs Standard Deviation Study (optional)


Ok this is where it gets serious.
On thinkorswim there is a study called PAIR RATIO
Other trading applications may call this Price Ratio or Relative
Performance, NOT to be confused with Relative Strength.
You are looking to plot the pairs ratio in order to determine how
far out of alignment your pair currently is.
Deviation from the mean is opportunity for the pairs trader
For thinkorswim we have built a more advanced version of this
study and have shared it with you!
49

Pair Ratio continued


In order to use the pair ratio you must enter BOTH symbols.
XLE - XOM
This combination plots the price of XLE minus the price of
XOM.
50

XLE - XOM
51

XLE - XOM continued


The value of XLE minus the XOM is significant in our study

XLE 73.30 XOM 83.35 = -10.05

The spread of XLE-XOM is currently trading at negative 10.05


52

Pairs Standard Deviation Study


The Pairs Standard Deviation Study looks at the pairing of
securities and plots them versus standard deviation.
If and when the pair trades are NEAR or OUTSIDE the 2
standard deviation mark an opportunity often exists to
execute a pairs trade.
53

Pairs Standard Deviation Study - TOS


Select a thinkorswim chart window.
Add your selected pair as SYMBOL1 - SYMBOL2 into the chart
symbol window. For example XLE XOM would be the symbol
for a XLE and XOM pair.
Click the Edit Studies FLASK icon.
From the Studies list on the left choose Pairs Standard
Deviation Study and either double click the name or right
click and choose Add Study.
Click OK to leave the Edit Studies and Strategies Window.
54

Pairs Standard Deviation Study XLE - XOM


55

Standard Deviation
56

Probability and Risk


When executing your Pairs Trades you are seeking
approximately a 2 standard deviation move from the mean
trading range of your Pair.

What is more likely, trading 3 deviations from the mean or


reverting to the mean?

Recall from our deviation curve 3 deviation moves are a rare


occurrence. Therefore, probability is on your side..
57

Mean Reversion
Statically speaking you are looking for MEAN REVERSION
Technical analysis will NOT help you here.
Some securities move in relative tandem.
You are going to plot 2 securities and view opportunities
whereby divergence of a PAIR exist.
The Spread between 2 heavily correlated securities is mean
reverting.
58

7. Historical Volatility
Historical volatility is defined as the annualized standard
deviation of the past stock price movement.
In other words its how much the stock is actually moving.
Most standard charting packages offer Historical Volatility
59

Historical Volatility Continued


What if one stock has a 30% historical volatility and the other
has a 60% historical volatility?
Check the historical volatility to ensure the Pair is not
misaligned.
Substantial historical volatility differentials can be a Pairs
killer
Check the historical volatility of EACH individual product to
confirm the volatility differential does NOT exceed a 20%.
60

XLE Historical Volatility


61

XOM Historical Volatility


62

What is a 20% difference in Volatility?


Lets make sure we do NOT have more than a 20% difference
between the historical volatilities of each product.

For example; 13.38% on the XLE and 15% on the XOM

Take 13.38(1.2) = 16

In this calculation we take the lower of the 2 historical vols, in this


case the XLE and multiply it by 1.2. Then check to see if our
paired product is within the parameter of 20%.
63

Volatility Side Note: IV and HV.


Depending upon the experience of the trader you may elect to
use Implied Volatility (options volatility) or Historical Volatility
(actual stock price movement).
In your initial alignment of your pairs trade you elect to use
historical volatility as to clarify the process of creating a
viable candidate.
Impending iterations of Pairs courses here at TheoTrade may
elect to use a more complex IV adjusted valuations for
aligning your underlyings.
64

8. Aligning shares of your Pair


Product A may not be equivalent to Product B
Alignment of the shares is essential in building a pairs trade
Products with high correlations often have similar volatiles
however this is NOT always the case.
You MUST avoid large deviations in volatility in order for your
Pairs Trade to properly align.
65

Notional Value Methodology


To avoid the chaos of Pairs trading lets use the
straightforward methodology of capital divided by the share
price of an underlying.

Note: without a heavy deviation in volatility from one product


to another you need go no further than this basic
methodology.
66

Notional value example


For example: we want to allocate a total of $20,000 to a
Pairs trade.
$10,000 long XOM
$10,000 short XLE

$10,000 divided by the share price = number of shares

$10,000 / 73.40 XLE = 136 shares XLE


$10,000 / 83.60 XOM = 119 shares XOM
67

9. Executing Upon Pairs trades


Its one thing to understand the logic of Pairs Trading.

Its entirely another in attempt to execute upon a given setup


and strategy.
68

Execution Risk
Pairs trades are placed in 2 separate markets, stock vs stock,
options vs option, futures vs futures or any combination
thereof.
When placing Pairs Trades you will encounter LEGGING RISK
69

Legging risks
In Pairs Trading you are placing 2 mutually exclusive orders into
separate marketplaces.

If buying one product and selling another these are technically 2


separate trades and are likely even routed to different exchanges
for execution.

Therefore, speed and accuracy of trade execution becomes vital.

With longer duration trades, execution becomes less imperative


nevertheless, lets make you proficient.
70

Legging risks continued


Where possible use marketable LIMIT orders.

These are LIMIT orders to buy or sell at the prevailing market


prices

The limit orders protect you in the event of a fast market


swing but often are executed nearly immediately.
71

Pairs Execution on TOS


thinkorswim offers an advanced order type called BLAST ALL.

Blast ALL does not guarantee the execution of both legs of


the trade however, this WILL let you fire both legs
simultaneously into the marketplace.

Blast All can be effective for futures, stocks, and ETFs.

I DO NOT suggest using Blast All for Options Trades


72

Blast ALL
73

10. Risk Reward in Pairs trades


For Pairs Trades have the mindset Risk $1 to make $1.
You are establishing trades based on statistical edge and
reversion to the mean.
When you execute upon a Pairs Trade you are seeking at or
near a 2 standard deviation occurrence.
Therefore, you are more likely we see reversion to the mean
rather than a 3 standard deviation move.
74

Risk controls
Risk $1 to make $1 is equivalent to risk $1000 to make
$1000.

Only you can determine how much capital you are


comfortable risking.

This is a new concept, trade small and stay small


75

Tracking your trades


Pairs Trades can be tracked via setting Alerts.

I strongly suggest you AVIOD STOP ORDERS


Stop orders could be placed on each unique product. However, it is
probable you could be down dramatically on one side of the pair and
up significantly on the other side. Stops will break the Pair Trade apart
and leave you exposed to directional market risks.
76

Why Stops dont work in Pairs


The trade below is flat on profit and loss however, the WMT
side of the Pair is taking a loss.
If you had set a stop order you could have been stopped out
of WMT ripping the Pair apart and causing larger losses.
77

11. Setting alerts


You can set individual alerts on each product you trade.

A more advanced trader could consider setting an alert on


the Pairs Trade itself.

Technology on trading applications varies greatly.

Thinkorswim does have alerts capability for Pairs trades,


enter one symbol minus the other
78

12. Exiting your pairs Trade


Profit or loss, when you hit your intended target risk/reward
EXIT the trade.

Sell the product you bought and buy the product you sold.

If at any point extenuating circumstances could or are


causing the breakdown of the correlation in your Pair
consider exiting the trade immediately.
Correlation meltdown is more typical is stocks.
79

Lets do it again. Follow the Criteria


1. Building a comparison chart
2. Finding a high correlaAon in two products, ETFs or products in the same
sector
3. IdenAfying visual divergence between highly correlated products
4. Check your Pair in MULITPLE Ame frames, 3 months, 6 months, 9 months
5. Select a Ame frame you intend to trade the Pair, days, weeks, months.
6. Pairs Standard DeviaAon Study at or near a 2 standard deviaAon move.
7. Check the historical volaAlity of EACH individual product does NOT
exceed a 20% dierenAal.
8. Alignment of the Pairs Trade number of shares to trade of each
product.
9. ExecuAon of the Pairs Trade
10. Prot and Loss risk and reward of your pair
11. Segng Alerts
12. Exit criteria
80

Take Less risk to start


Consider ETF vs ETF Pairs trading to start your journey into
Pairs trading.

There are no heroes in markets, only those who survive and


live to trade another day J
81

ETF versus ETF


Personally, I am most comfortable educating and employing
PAIRS TRADES with ETF vs. ETF.
ETF products can gap up or down however, have significantly less
risk for Pairs Trades than do equity products.
ETFs are the single most effective way to execute and LEARN
Pairs Trading Strategies.

We will cover stocks, options, and futures contracts later in the


session.
82

ETF Pair Candidates


Examples may include but are not limited to
SPY vs QQQ
SPY vs IWM
QQQ vs IWM
DIA vs IWM
OIH vs XLE
XRT vs SPY
XLK vs SPY
SLV vs GLD
TLT vs SHY
XLU vs SPY
HYG vs JNK
XRT vs XLF
83

XRT versus XLF


84

Correlation of XRT versus XLF


85

Pairs Standard Deviation


86

Pairs trading stocks


With greater risk comes boundless rewards.
Pairs trading may be extremely advantageous in stocks
though it carries additional risk.
When initially trading Pairs you may want to consider ETF
products, get the logic and methodology down first, then
progress into higher risk products.
87

Stock versus Stock


You would think I would cover stock pairs trades first however, stocks
take on additional risks:
Earnings announcements
News
Takeovers (acquisitions can kill a pairs trader)
Upgrades and downgrades
Stock buy backs
Bankruptcy
CFO taken away in handcuffs or caught in compromising situations with
their minions.
Accounting Irregularities
And 100 other reasons!
88

Pairs on Stocks WARNING


Lets please recall you are considering shorting a stock and
theoretically, a short position can have unlimited risks.

Select a candidate from the S&P100.

You limit stock selection to LARGE caps to minimize the risk of


your short candidate being acquired.

The probability of a S&P100 stock being acquired is greatly


diminished as these are the 100 largest companies by market
capitalization.
89

ETF against primary Equity in the ETF


ETFs have correlations with other ETFs but you can also trade
an ETF against one of the primary components of the ETF
itself.

For example the XLF is the SPDR Financial Sector ETF. You
could trade the XLF against one of the major financial
securities.

What securities comprise the XLF?


90

Getting to know your ETF product


Trading ETF is one thing, but in order to make effective PAIRS TRADES
it is in your best interest to research what stock comprise the ETF
product.
YAHOO FINANCE or most brokers offer this information.
91

Pairing options for stock replacement


Options can be used in Pairs trades in many forms.
Synthetic Stock Replacement is often the strategy of choice.
Synthetics looks to use options to replace stock whereby
conserving your capital.
92

Options in Pairs trades


Select a pairs candidate using the aforementioned criteria.
Use an in the money CALL with a delta greater than .90 to
substitute for the long stock position.
Use an in the money PUT with a delta greater than .90 to
substitute for the short stock position.
93

Options Pairs Contract Size


Standardized Options Contracts are equivalent to 100 shares
of stock.
If you are trading a $100 stock paired with a $50 stock you
will need 2 contracts of the $50 stock for every 1 contract of
the $100 stock.
Calculate the SHARES of STOCK first then convert to Options
Contracts.
94

Options Contract Size Example


SPY long trade vs IWM short trade. You are buying the SPY and
selling the IWM.
50k investment on each side of the pairs trade .
SPY @ 50,000 / 230 = 217 shares of SPY
IWM @ 50,000 / 136 = 368 shares of IWM

This is not going to be perfect or pretty and you must round ~


2 contracts of a .90 call in the SPY
4 contracts of a .90 put in the IWM
Contract expiration/duration is dependent upon intent of the
trade
95

Legging Pairs Options


For Pairs Trades in options markets work each order
individually and start at near MID PRICE.

In the money options have wide bid/ask spreads and


therefore require more stringent order execution techniques.

Again, I do not suggest using Blast All with options trades as


you will be giving up a huge edge in the bid/ask spreads
96

High Probability Split Iron Condor Strategy


Pairs Trading can be effective however, to get the best bang
for your buck you may want to employ these trades around
options spreads.

What's not to like? Take the Pairs idea and criteria apply it to
Defined Risk options spreads.
97

Pairs Trading: Split Irons


The logic of the Split Iron is identical to an Iron condor yet spread
into 2 separate products.
Ideally Split Pairs Irons are designed for deployment within Index
and Index related products or ETFs

Trade Design:
Selling an out of the money call spread in the strong product.
Selling an out of the money put spread in a separate but
correlated weaker product.

Strength and weakness determined by visual divergence.


98

Split Irons Criteria


Entrance Criteria:
1.Initially consider this trade setup for index products such as
RUT, SPX, IWM, SPY etc.
2.Use Options cycles from 23 to 90 days prior to expiration.
(shorter duration not advisable)
99

Call side of split Irons


3. Sell out of the money call spreads on the product you want
to be short.
a) Sell Call with between a .11 to .15 delta
b) Buy further out strike, use $2 wide spreads in ETFs and $5-10 wide
spreads in the major index products RUT, SPX.
c) EXECUTE THE TRADE AS A VERTICAL SPREAD
100

Put side of split Irons


4. Sell out of the money put spreads in the product you want
to be long.
a) Sell Put between a .13 to .20 delta
b) Buy further out strike, use $2 wide spreads in ETFs and $5-10 wide
spreads in the major index products RUT, SPX.
c) EXECUTE THE TRADE AS A VERTICAL SPREAD
101

Complete Split Iron package


5. Use equal contract size on your vertical spreads.
6. Work the orders and execute the vertical spreads
individually as they are in two separate products, Note
margin will be held on each vertical spread as they reside in
different products.
102

High Probability Split Iron Condor Strategy


103

Closing Split Irons


The most significant factor in successfully trading Split Irons
will be the consistency when closing the position.
Close individual vertical spreads having achieved 50%-75% of
the initial premium collected. (on EITHER side of the trade)
But what if your spreads are threatened?
104

Exiting Split Irons


Exit the vertical put spread if the short put strike exceeds -.50
delta.
For example delta of short put goes from -.17 to -.50 exit the
Iron Condor IMMEDIATELY.
On many trading platforms you can set DELTA ALERTS.
105

Exiting Split Irons


Exit the Iron Condor if the short strike call exceeds .45 delta.
For example, if delta of short call goes from .08 to .45, exit
the Iron Condor IMMEDIATELY.
On many trading platforms you can set DELTA ALERTS.
106

Futures contracts and Pairs trades


Futures contracts are no laughing matter; they are highly
leveraged chocolate covered hand grenades.
Ok that was funny but seriously, tread carefully with futures
contracts.
Did I mention futures were my first love? We met just out of
college on the floor in Chicago
107

Pairing futures: Notional Value


Solve for the notional value of the underlying contract.
The emini SP500 uses .25 increment ticks
Each tick is worth $12.50
There are 4 ticks in a $1.00
$12.50 X 4 ticks = $50
The emini SP500 is currently trading for 2300
2300 X $50 = $115,000 is the notional value of 1 emini SP500
futures contract

Yep that is a big boy product!


108

Pairing futures: Notional Value


Solve for the notional value of the underlying contract.
The emini NASDAQ uses .25 increment ticks
Each tick is worth $5.00
There are 4 ticks in a $1.00
$5.00 X 4 ticks = $20
The emini NASDAQ is currently trading for 5150
5150 X $20 = $103,000 is the notional value of 1 emini NASDAQ
futures contract
109

Intraday pairs trading


For the fast and the furious some of the most advantageous
pairs trades can exist within intra-day trade.
Intra-day pairs trading necessitates a strong knowledge of a
trading application and the ability to PULL THE TRIGGER on
trades.
Several vehicles can be used for intra-day Pairs Trades
including Stocks, ETFs, and Futures contracts.
Selection of a product is often based on experience in the
markets and margin requirements.
110

Savvy thinkorswim traders


If you are a bit more savvy with TOS you can even use PAIRS
quotes.

For example, WMT TGT

Or with a ratio SPY 1.35*IWM


This would load a quote and/or an order to trade 100 shares of SPY vs
135 shares of IWM
111

Learning Objectives
Introduction to Pairs Trading
Discover and Build Correlation Charts and Trades
Learn Entry and Exit Criteria for Pairs Trades
Aligning Pairs Trades
Executing Trades Upon Divergences and Statistical
Opportunities
High Probability Split Irons
Converting Pairs Trades for Options and Futures Execution