An article I wrote on December 3, 2008 titled "Single-Click Stock Pair Trading at Its Finest" has generated a lot of interest from our customers. So in the TOS tradition, let's ramp it up and utilize Theta decay and High Probability trading to the Stock Pair Trading strategy. As you might realize, stocks have the most risk as they respond most directly to the pair change. If the spread moves your way, the stock positions move point for point with the spread. But if you're wrong on the direction of the pair spread, then you'll lose point for point with the spread. We could use a single option; that is, you could buy an SPY call and buy the IWM put. But the problem with single options is that you're battling time decay and potential drops in implied volatility. ***Editors note; presently the volatility index, VIX, has traded below the 50+ level for the first time since its spike to 80+ in October, which I am told by many charting experts would signal an implied volatility move to the more historical volatility level of 30+.

1. Verticals are the High Probability way to trade using the pair trading strategy. The advantage of verticals is that in the right circumstances, you can find long and short verticals in the two stocks or indices that will generate a small credit, and that credit can turn an otherwise scratch trade (no profit or loss) into a small winner if the spread of the pair does not move the way you want it to.

2. You also could consider using both slightly OTM (out of the money) short verticals to form the "Iron Condor" pair position if that will make the most of the way you think the spread will move. I find myself using this most with pair trading! For our example sell the SPY OTM put vertical (bullish) and sell the IWM OTM call spread (bearish) creating a high-probability, Theta-positive position- Ah, my favorite!

In this example we presently we have an approximately 70% probability of success in the stand alone trades with a combined risk of 2.90$ and a combined reward of 1.10$ with an impressive combined 1.17$ of positive Theta decay. Nice!

thinkorswim, Inc. and its employee, Tony Battista, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.