The idea behind paired trades is that while sectors move in tandem or against each other, often there will be leaders within a sector and can present different setups than the sector as a whole. This presents a good paired trade opportunity to collect premiums on both trades.
For example, say that NVDA has a split news announcement with a great bull setup but don’t want to chase. You also notice that AMD (same sector) has been rejecting resistance and is forming a double tap.
Then in this case we can take a bearish position on AMD and a bullish position on NVDA. The two positions will hedge each other in the event of a broader sector move and with luck, both setups could play out with the individual ticker setup “overpowering” the sector move.
What are the 3 possibilities?
1) So the ideal situation would be if SMH moves down and brings AMD down with it, and NVDA continues to move up because of split news hype.
2) The other more neutral common scenario would be SMH moves down, and both AMD and NVDA both go down. No problem because our AMD bear position hedged our NVDA bull position.
3) The worst scenario is where everything fails, and AMD breaks out, SMH moves up but for some reason NVDA isn’t carried up by the market. This is less likely to occur because broad sector moves generally carry all the tickers with it.
Of course the reason we do this is because the trade setups of the tickers presented are different from each other, but belong in the same sector creating a good opportunity for a hedged sector play with both sides having the possibility of panning out if trade setups were ‘correct’. (Note that its best if you use premium selling strategies so that you could still make a profit even if the move is not ideal – for example a butterfly which can provide a range of profitability for a trade instead of unidirectional)