### PAIR TRADES CAN BE THETA OR VEGA WEIGHTED

Theta and vega weighted are the most common methods of weighting pair trades. Dollar gamma weighted is rarely used and is included for completeness purposes only.

• Theta-weighted trades assume proportional volatility changes eg: if stock A has 20% implied and stock B has 25% implied, if stock A rises from 20% to 30% implied that is a 50% increase and stock B rises 50% to 37.5% implied
• Vega-weighted trades assume absolute volatility changes eg: if stock A has 20% implied and stock B has 25% implied, if stock A rises from 20% to 30% that is a 10 volatility point increase and stock B rises 10 volatility points to 35% implied

Pair trade between two securities of same type should be theta weighted

• If a pair trade between two securities of the same type (ie, two indices, or two single stocks) is attempted, theta weighting is the most appropriate. This is because the difference between a low volatility security and a high volatility security (of the same type) usually increases as volatility increases (ie, a proportional move).

Pair trade between an index and a single should be vega weighted

• The implied volatility of an index is dependent not only on single-stock implied volatility but also on implied correlation. As volatility and correlation tend to move in parallel, this means the payout of a vega-weighted pair trade is less dependent on the overall level of volatility (hence the volatility mispricing becomes a more significant driver of the P&L of the trade)