Chapter 27: Arbitrage 455 
expensive with respect to the other one, historically. Then, when the stocks return to 
their historical relationship, a profit would result. In reality, some fairly complicated 
computer programs search out the appropriate pairs. 
The interest on the short sale offsets the cost of carry of the stock purchased. 
Therefore, the pairs trader doesn't have any expense except the possible differential 
in dividend payout. 
The bane of pairs trading is a possible escalation of the stock sold short without 
any corresponding rise in price of the stock held long. A takeover attempt might 
cause this to happen. Of course, pairs traders will attempt to research the situation 
to ensure that they don't often sell short stocks that are perceived to be takeover can­
didates. 
Pairs traders can use options to potentially reduce their risk if there are in-the­
money options on both stocks. One would buy an in-the-money put instead of selling 
one stock short, and would buy an in-the-money call on the other stock instead of 
buying the stock itself. In this option combination, traders are paying very little time 
value premium, so their profit potential is approximately the same as with the pairs 
trading strategy using stocks. ( One would, however, have a debit, since both options 
are purchased; so there would be a cost of carry in the option strategy.) 
If the stocks return to their historical relationship, the option strategy will 
reflect the same profit as the stock strategy, less any loss of time value premium. One 
added advantage of the option strategy, however, is that if a takeover occurs, the put 
has limited liability, and the trader's loss would be less. 
Another advantage of the option strategy is that if both stocks should experience 
large moves, it could make money even if the pair doesn't return to historical norms. 
This would happen, for example, if both stocks dropped a great deal: The call has lim­
ited loss, while the put' s profits would continue to accrue. Similarly, to the upside, a 
large move by both stocks would make the put worthless, but the call would keep 
making money. In both cases, the option strategy could profit even if the pair of 
stocks didn't perform as predicted. 
This type of strategy- buying in-the-money options as substitutes for both sides 
of a spread or hedge strategy - is discussed in more detail in Chapter 31 on index 
spreading and Chapter 35 on futures spreads. 
FACILITATION (BLOCK POSITIONING) 
Facilitation is the process whereby a trader seeks to aid in making markets for the 
purchase or sale of large blocks of stock. This is not really an arbitrage, and its 
description is thus deferred to Chapter 28.