Pair options

In Finance, Pair Options are financial derivatives which are based on the relative performance of stocks within a given pair of correlated assets like stocks or indexes. Investing in Pair Options requires choosing one stock from the pair that the investor predicts will be a better performer. Pair Options are available OTC (Over the Counter), directly from Market Makers, Recently NASDAQ OMX has also launched Options on relative performance of leading stocks v s indexes. Pair Options are Exotic Options that resemble another type of exotic options : Rainbow Options that are based on more than one underlying asset.
Pair Options trading is similar in many aspects to Pairs Trade, a market neutral strategy which was pioneered by Gery Bamberger, and is based on opposite trading of two securities.
The concept of options on relative performance of stocks was also often discussed as a vehicle for managers compensation
Concept of Pair Options
With Pair Options the concept is that the trader is allowed to take a position on one stock over another within a predetermined highly correlated stock pair. The fact that the two stocks are highly correlated makes Pair Options a market neutral instrument, meaning the direction of the overall market does not affect its win or loss, and help the trader avoid the market risk.
A Pair Option has commonly predetermined returns according to (1) the stock initially chosen as the better performer and (2) the relative performance of the stocks that make up the stock pair.
Denoting SA(T) & SB(T) as stock A & stock B respective spots at expiry and SA(0) & SB(0) their original spots.
If the trader chooses B to outperform A and if he is promised a $XY in case he is right, the payout is given by: ADD
Types of Pair Options
The 2 main types of Pair Options are Fixed Pair Options and Floating Pair Options:
Fixed Pair Options
Fixed Pair Options follow the relative performance of the pair’s underlying stocks from the time the investor opens the trade to the expiry time. The pair’s underlying stocks relative performance measurement starts when the trade is opened. In addition, the return percentage, expiry time and position size are all fixed for a period of time.
Floating Pair Options
A Floating Pair Option follows the pair’s underlying stocks performance from the option start time (beginning of the day, week or month) to the option’s expiry time. So when a trader opens a Floating Pair Option there is usually a gap between the underlying stocks performance, so 1 stock will be "in the money," while the other stock will be "out of the money." Also, it can be opened or closed during any time during the option's period of trading.

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