You can increase your profit potential by managing your pairs in the manner of POWR options.
In some previous articles, we have discussed the advantages of the pairs trading approach. Pairs trading is taking a bullish position on a stock that you believe will perform better than similar stocks that take a bearish stance. A classic example of buying Ford/selling General Motors if you think Ford will beat GM.
Instead of using simple stocks to represent perspectives, using options is better in many ways. why? Limited risk, low upfront cost, in addition to three lesser-known but very important advantages.
A brief description of recent trades in the POWR options portfolio will help you understand the benefits of these “discreet” trade controls we employ.
Our trading pair of choice was the recently completed Cheniere Energy Partners (CQP) bullish call and Sunoco (SUN) bearish put. Both oil-related names are highly correlated stocks, meaning they rise and fall together on a regular basis.
First deal on February 27th shown below:
action to be taken
Buy $50 Put $4.10 with 0.20 discretion to open Sunday 16 June 2023
each option It costs about $410 per contract.
action to be taken
$4.00 for a $50 call purchased to open CQP 6/16/2023, with 0.20 discretion
each option It costs about $400 per contract.
Here are the reasons for the deal: Cheniere Energy Partners (CQP) was his A-rated (Strong Buy) stake, while Sunoco (SUN) was his C-rated (Neutral) stake. Both are MLP Oil & Gas in the same industry.
We would expect these two stocks to behave similarly as they are both oil stocks. In fact, they did so for nearly his entire 2022 term.
However, the much lower-rated SUN would outperform the higher-rated CQP by significantly more than 17% in 2023. The graph below shows how these two usually related stocks diverged. Trading the pair was done in hopes that the CQP would outperform the SUN over the next few weeks and spreads would tighten. This outperformance leads to spread convergence and profit.
This happened, but it’s not a big deal. The spread converged about 3.5%, and from 17.7% he narrowed to 14.15% as both stocks plummeted.
But our pair traded very well. As you can see below, we closed on March 15th.
As shown in the table, you won $490 on the SUN put and lost just $290 on the CQP call for a net gain of $200.
The initial cost of trading the pair was $810. A net profit of $200 equates to a return of 24.69%. The duration was just over two weeks. Additionally, at the opening of the trade, we hedged two highly correlated stocks with a bullish call and a bearish put.
Thus, the two stocks that make up the pair trade began to converge as expected, but that convergence certainly did not account for the bulk of the profit.
Instead, the three things listed under Gamma, Time Decay Management, and Implied Volatility Analysis are the hidden benefits of the POWR option pair trading approach.
gamma
Options move in curves instead of straight lines. The greater the favorable movement of the underlying asset, the more favorable the relative movement of the option. Conversely, the greater the unfavorable movement of stocks, the less movement of options.
The initial delta at the opening of the trade changes as the stock price changes. This rate of change in the option delta relative to the stock price is called “gamma”.
Gamma is an options metric that represents the rate of change in an option’s delta per point movement in the underlying asset’s price. Delta is how much an option’s premium (price) changes when the price of the underlying asset changes by 1 point.
Purchasing an option lengthens the gamma. This means that if the selection direction is correct, it is more correct. It also means that if you go the wrong way, you will make fewer mistakes. Sound like real? That’s because time decay is a bad part of buying options.
time decay
Options are a waste of money. It loses a little bit of its overall value with each passing day. This concept is called time decay, or theta to use the Greek. While gamma is the positive side of option buying, theta is definitely the bad side. POWR Options are acutely aware of time decay. This is why he almost always chooses to exit options well before expiration (usually he is around 30 days).
The chart below shows how steeply the option time decay actually happens in the last 30 days or so before the option expires. Exiting before that and collecting the time premium, or residual value of the option, is critical to long-term success.
Indeed, closing the CQP/SUN pair in just a few weeks makes Time Decay less relevant.
A purchase with no or zero expiry date should be avoided at all costs. So far I’ve achieved that with the POWR option.
Implied Volatility
At POWR Options, we always look closely at Implied Volatility (IV) when considering potential trades. In our opinion, this is one of the most important factors for options trading.
Implied volatility is a measure of how much the options market expects the price of the underlying asset to move. A higher IV means a larger expected move, a lower IV means a smaller expected move. IV is also essentially the price of the option. The higher the IV, the more expensive the option. A low IV makes the option cheaper.
Because we buy options all the time, we focus on buying options with relatively low implied volatility. A lower comparative IV means that the option price is slightly lower. This is always good.
The current IV percentile ranks to the current implied volatility position compared to the previous year’s IV range. The lower the percentile, the lower the current IV. 100% means the IV is the highest it has been in the past year. 0% is the lowest. 50% is about average.
We try to buy options that are trading well below 50%, i.e. options that are relatively cheap. Looking at both the SUN and CQP options below, you can see that both were well below his 50% IV percentile when purchased on February 27th.
CQP IV
Sun IV
You can see below how the implied volatility (IV) jumped from 20.85% when buying the SUN put to more than 36% when closing the position. Another advantage of buying cheaper or lower IV options. It also shows how the delta of these bearish puts moved from -65 to -80 (the positive effect of gamma).
The same scenario was deployed with CQP calls.
In addition to the power of POWR ratings, the expected convergence of related stocks can be a crucial advantage when constructing pair trades. Understanding the somewhat hidden benefits of gamma, time decay management, and implied volatility analysis turns trading pairs into trading his POWR pairs. This approach makes the odds even more favorable.
POWR option
what next?
If you’re looking for the best options trading for today’s market, check out our latest presentation. How to trade options with POWR ratingHere’s how to consistently find top options trades while minimizing risk.
If this appeals to you and you would like to learn more about this powerful new options strategy, click below to access this timely investment presentation now.
How to trade options with POWR rating
all the best!
Tim Bigham
Editor, POWR Options Newsletter
SUN shares closed at $41.60 on Friday, down $0.32 (-0.76%). Year-to-date, the SUN is down -1.79%, while the benchmark S&P 500 index is up 1.98% over the same period.
About the Author: Tim Bigham
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim, and 3 years as Market Maker at First Options in Chicago. He appears regularly on Bloomberg TV and TD He contributes weekly to the Ameritrade Network ‘Morning His Trade Live’. His overriding passion is to make the complex world of options easier to understand and more useful to the everyday trader.Tim is the editor POWR option Newsletter. Read Tim’s bio and links to his latest articles.
post 3 Better Ways To Favor Your Profit Potential With The POWR Pairs Approach first appeared StockNews.com
