Risks of Trading Cointegrated Stocks with Options

Summary

The document considers replacing a stock pair trade based on cointegration with long at-the-money options: calls on the underperforming stock and puts on the outperforming stock, sized using the cointegration hedge ratio. The response highlights three key requirements for evaluating this change: a reliable volatility forecast, a forecast for how long convergence may take, and careful accounting for transaction costs and liquidity.

The answer cautions that options add complexity and that low implied volatility or a lack of scheduled announcements alone does not establish an edge. The discussion provides no backtest, pricing analysis, or detailed treatment of how option quantities should translate the stock hedge ratio. It therefore serves as a checklist of unresolved modeling and implementation risks, rather than evidence that the options version improves on a direct long-short stock position.

Key ideas

• The proposed trade buys calls on the underperforming stock and puts on the outperforming stock.
• The cointegration hedge ratio is suggested as a guide for sizing the option positions.
• A useful evaluation needs forecasts for volatility and the time to spread convergence.
• Transaction costs and option liquidity can erode the strategy’s returns.
• The document offers cautions but no evidence that the options approach outperforms stock pairs trading.

Tags

# Trading pair of cointegrated stocks using options


# Trading pair of cointegrated stocks using options












Suppose stock A and B are cointegrated and a trading signal is dervied from it. Instead of long the underperforming and short the over-performing stock, what about long at the money call and put options for the underperforming and overperforming stock respectively, at quantities equivalent to the hedge ratio from the cointegration model?

Let's assume the current IV of both options are low and there are no upcoming earnings call/major announcements within the next 2* half lives of the spread. Are there other risks to be aware of?

## Answer by Newquant (score 1, accepted)

https://quant.stackexchange.com/a/80592

How's your vol forecast? Time to convergence forecast? + transaction costs and liquidity considerations.

Unless the above are nailed and have demonstrable edge then I'd argue you're adding complexity needlessly.

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