Pairs Trade – NFLX vs STMP

See the Update on this blog post at the end.

Since closing 2 pairs trades this week, my stable for this type of trade was looking quite thin. So I whipped out one of the tools I use – the Correlation Tracker - and looked for a stock that would be a good pair to NFLX (Netflix Inc.).

I bring you STMP (Stamps.com Inc). Here is a snapshot of the correlation between the 2 stocks:

As you can see, there is a massive range between the two stocks that can be played for some mean reversion. Based on closing prices today, January 20, 2012 you can consider the following trade:

1) Short 4 lots of STMP at 30.31

2) Long 1.2 lots of NFLX at 100.23

For those that prefer the Options approach, consider this trade:

1) Long the February 30/25 Put spread for $1.50 on STMP

2) Long the February 105/115 Call spread for $3.00 on NFLX

Update: The long NFLX portion of this trade has stopped out for me (2/10/2012), but the short STMP portion has remained. The stock is testing some support from mid-December 2011 so be mindful of this if short.

  • Sal

    Looks like a great spread – Bigger’s Spread Analyzer shows good cointegration. I was wondering if you could share some thoughts on how you structure your options trade. Specifically, I’m wondering about the delta of the positions relative to the max payout. Given that you’ve chosen to use debit spreads, the upside is capped (though you have reduced the impact of a drop in vol and time decay).

    I haven’t seen much on using options in pairs trading aside from a chapter in McMillan’s McMillan on Options. He advocates higher delta single options (more ITM) with the philosophy that a big move will make the gains from winning option far outweigh the loss of the capital from the losing one. Basically, the losing option can only go to zero but the winning one can increase (theoretically) infinitely.

    Thanks.

    • dwmuniz

      Thanks for reading. On the topic of Option selection, I often end up with numerous choices in the pairs. I will use ITM options frequently with an options trade, but really focus on where the IV edge is. One specific idea I am mulling over is coming up with an Options Pairs trade that has a twist – you use the option of a high IV stock to purchase the option of a low IV stock that you are interested in.
      More to come on that.

  • Sal

    Look forward to reading the next post. Selling the high IV option (or spread) to finance the purchase of the low IV option – kind of a risk reversal structure – does make sense. Would be interesting to play out all the scenarios of the pair structure (pair diverges, reverts to mean, stays constant) and possible movements of the underlying and see what the results would be for different options structures (selling vol, single option purchases, spreads, etc).

    • dwmuniz

      So far this trade is a winner with NFLX announcing earnings and getting a nice move after hours.

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