Have you ever heard of pairs trading? It’s a clever and fascinating investment strategy used by many hedge funds. It involves buying and selling two assets that are highly correlated, with the aim of profiting from short-term price divergences between them. It’s a fantastic way to hedge against market risk while still making money. And the best part? It’s a market-neutral strategy that works in both bullish and bearish market conditions.

Here’s an example: let’s say you’re considering a pairs trade with two similar stocks that are usually moving in tandem with each other – PepsiCo (PEP) and The Coca-Cola Company (KO). However, today you notice something different – PepsiCo is trading at a higher price than usual, while Coca-Cola is trading lower than its usual price. This could be an opportunity for a pairs trade. You could buy Coca-Cola (KO) and short PepsiCo (PEP), betting that the prices will eventually converge back to their mean. And if your bet pays off, you could make a tidy profit!

While the previous example with PepsiCo and The Coca-Cola Company is a great illustration, let’s take a look at a fresh example for today. The Russell 2000 and Nasdaq are two indexes whose overall performance has been similar and whose correlation is generally very high. However, in the second half of March 2023, they have diverged, creating a potential opportunity for a pair trade. Take a look at the chart below.

Now, the question is: how can I profit from this divergence and bet on the correlation between the Russell 2000 and Nasdaq indexes to eventually converge back to their mean? Since trading indices directly isn’t possible, I’ll utilize ETFs instead. Specifically, I’ll use the iShares Russell 2000 (IWM) to track the Russell 2000 and the Invesco QQQ (QQQ) to track the Nasdaq 100 Index. By using ETF options, I can optimize my capital efficiency and strategy, which would give me some margin for error while still being profitable

Both IWM and QQQ have highly liquid options markets. However, the iShares Russell 2000 ETF is currently trading at around $170 per share, while the Invesco QQQ is trading at about $320 per share. As such, I’ll need to sell one call option on QQQ and two put options on IWM for each pair trade. Consistent with my personal trading style, I’ll sell options with a delta of approximately 35 and closest to the 45-day expiration cycle, which in this case is May 19th, 2023. My total credit received for this trade will be $1,300, with a profit target set at 25% of the initial credit.