What if one put on a pair trade? What would the results be then? Selling the aforementioned SPY straddle and buying, for example, the QQQ straddle. This is exactly what KOTM did. The thinking behind this strategy could be that SPY volatility is expensive and QQQ volatility is cheap. Another way to think about this trade could be that one is just covering their downside, for if the market crashed the short straddles will get crushed, but the long straddles will be rewarded. A risk to this strategy could be a year 2000 type scenario; where one index acts dramatically different than the other (even if we are indeed long QQQ vol, the idea of uncorrelated markets is a risk).

The results to this study were indeed very interesting. One would think, in theory, the theta (time decay) and long premium would end up being a losing trade, but it was not. The long straddles ended up adding to the net profit. The QQQ total return was a losing trade most of the time, which could be predicted.  The spikes higher and lower were from crashes or spikes. The QQQ made $4.95 since Feb of 2005, in addition to the $48.72 the SPY made. The important part of this exercise is that the long straddles did offset losses during crashes.

The SPY was $116 in Feb of 2005 and is around $140 now, this trade made $48.72 points or around 42% total relative to SPY in ’05 or 35% total relative to SPY now. The QQQ made $4.95. The index was around $40 in Feb of 2005 and around $65 now; 12% total return relative to 2005 and 7.6% total return relative to now.

The trader would have to size the amount of contracts accordingly; relative to the size of both index products in order to do a proper pair trade…along with many other things. Below is a chart of the total return.

KOTM is clearly not suggesting selling an unlimited risk spread, but the data is interesting. More to come on this project.

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Author

salerno.mark.a@gmail.com