Discretionary trading unsuspended (temporarily)

Okay, I know I’m going down the road of system trading and I’ve suspended discretionary trading (on a temporary basis), but sometimes a trade looks like it can’t lose.

At least that’s what I thought with a seemingly brilliant hedged pair: long equal shares of FAS and FAZ. All one needs to make this trade work is to buy them when they’re trading near the same price and pray for one of them to breakout. The basic idea is that if they move in equal percentage moves, the one that moves higher will compound itself while the laggard slows its Zeno-like approach to zero. Instead of the traditional pairs trade where one bets on a reversion to the mean, and for high flyer and low rider to get back together, this one relies on the opposite to happen. A divergence of the underlyings makes this a winner. It’s sort of an anti-pairs trade.

So I bought FAZ at $12.00 and FAS at $6.20. Not exactly near the same price, but why get picky here. Wouldn’t you know it that the two devils decided on a rendezvous at around $8.40. That’s a $3.60 loss on FAZ offset by a $2.20 gain in FAS, for a net loss of $1.40. Okay, it’s a rough start. But this is as bad a loss as one can expect, right? After all, if FAZ continues to drop, FAS will continue to rise and before you know it the trade will be back to break-even.

But someone must have figured out what I was trying to do and decided to let these two languish near each other, which is the absolute worse thing that could happen. And to make matters worse, it appears that both FAS and FAZ have some sort of price decay built in because I seem to recall they met around $9.00 just a couple weeks ago.

What does one do with long stock that isn’t moving. Well it seems the only sensible thing to do is sell call options against it, just outside the money at a place that is affectionately called ‘junk’ by premium sellers. So that’s what I did. I sold the MAY 10 call in FAZ for $1.10 and the MAY 10 call in FAS for $0.61. The grand total is $1.71.

Now the worst thing that can happen is for FAS or FAZ to breakout. Depending on which one did it, I would either lock in a loss of $0.29 (FAZ) or realize a gain of $5.51 (FAS). Mind you that accounts for only half the trade. Where the tanking stock settles determines the trade’s total PnL.

The next time I take this trade is when both FAS and FAZ are trading within dimes of each other. Then buy both and sell OTM calls on both. Basically, you get double the premium on the covered call because only one can go up at a time. You still have the risk of the selloff victim, but does anyone really see either one going to zero?

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