CNQ Bear Call Spread and XOP Bull Put SpreadI am not sure if this is the right forum for this but anyway... Pairs trading is a statistical arbitrage strategy designed to exploit short-term deviations from a long-run equilibrium pricing relationship between two stocks. This is a well known strategy used by hedge funds and institutional investors. I have previously used pairs trading by trading two correlated stocks. Normally a trader would go long on an underperforming stock and, at the same time, go short on an outperforming stock. If properly constructed this approach eliminates net equity market exposure and the performance is then only depends on the relative performance of the two stocks. As you can see from the above chart CNQ and XOP are correlated and move in a very similar fashion. It is not surprising as they both have very similar drivers - the price of oil and gas. CNQ has recently been outperforming XOP so to construct a pair trade a trader would short CNQ and go long XOP.
For this trade I utilised stock options by selling two January 2016 credit spreads at the same time - CNQ $22/$23 Bear Call Spread for $0.26 and XOP $27/$28 Bull Put Spread for $0.32. The total credit received from these two spreads - $0.58. The maximum risk for the trade is $1.42 per spread and the maximum return is $0.58 per spread (excl. commissions). If the spread between these tow stocks returns to mean, I should be able to profit from the trade. Let's see how this trade performs over the next 4 weeks when the Jan options expire.
