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Let us say I want to pursue a pair trading strategy between stock A(long) and stock B(short).

Can I replace this stocks with their synthetic option equivalents and have the same risk reward profile as if I had bought and shorted the actual underlying?

i.e Is the synthetic equivalent exactly equal to the underlying position?

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This is very interesting. You probably can create synthetics for a pairs trading strategy however I believe that you need to consider the pros and cons.

Pros: 1. You can create a short position if the stock is hard to borrow. 2. You do not need to worry for dividend payments when shorting.

Cons; 1. It can be a bit expensive (transactions/commissions) 2. What expiration to use? What if you expect the pair to revert in 30-days but it doesn't actually do until 60?

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  • $\begingroup$ Thanks. I understand the con about reverting in sixty days. However the option strategy will be cheaper,not more expensive. Commissions at IB are low and the options will require less capital upfront. Please feel free to correct. $\endgroup$ – Victor123 Nov 22 '14 at 15:24
  • $\begingroup$ @Victor123: what is IB here? In general, of course cash required for options is less than for stocks so you can use leverage. Note however that synthetic position have different interest/dividend exposure than stock, which can be a benefit (or not, depending on your strategy). $\endgroup$ – Ulysses Nov 24 '14 at 9:18

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