Portfolio diversification redux: think like a trader
Diversification isn’t just about stocks, bonds and cash. When hedging the risk of an options portfolio, think about price, time and volatility.
Photo by Dan Saelinger
Key points to remember
- When diversifying an options portfolio, think in terms of price, time and volatility
- Hedging should be an integral part of an options trader’s plan
- Know which options strategies could potentially help reduce overall directional risk
Long-term investors know better than to put all their eggs in one basket. Options traders, on the other hand, tend to break eggs. If you don’t break more than you keep, you come out ahead. That’s the idea, anyway.
Eggs and baskets are just a simple way to tell not to load too many shares of a sector in case the sector collapses. This is, as you know, the most fundamental principle of diversification.
As an options trader, you are probably trading momentum stocks that you follow or that show up in your daily analyzes. There probably isn’t a lot of sector diversification going on because you think less about a company’s balance sheet or future profit potential than what a price chart tells you about tomorrow’s stock on a market. given action. For short-term options traders, the diversification objective focuses on price, time and volatility (flight).
Does that cover the new diversification?
Diversification is generally characterized as a strategy designed to reduce your overall risk. But it’s really meant to smooth out gains when the going is good. You could be diversified with bullish investments across a range of stocks, sectors, or even indices. But if the market goes down, you could still lose, as most stocks tend to correlate when the market crashes.
This is called “systematic risk” —the risk that the entire market, or at least the industry in which you invest, could move against you. For options traders, it is not enough to diversify into different sectors, especially when trading options that carry other risks than directional (price) risk of stocks. Now, that doesn’t mean you are giving up on diversification altogether. But for options traders, hedging should be an integral part of your trading plan because on the one hand you have the systematic price risk of the market and on the other hand you have the risks of time decay and decline. modification of implied volatility (IV).
So what’s the difference between diversification and hedging? In short, diversification is all about sharing the love and spreading your investments across different stock market sectors or groups of assets (like stocks, bonds, and cash). Hedging involves making one “offsetting” transaction in the hope of reducing risk, essentially putting on another transaction in the opposite direction. When hedging with options, price, time, and volume are usually a priority.
Cover like a pro
Because market makers (who usually take the other side of your trade) hedge every trade, let’s start by taking a look at their playbook. Let’s go over a typical market maker hedging progression using the buy option of May 135 in Figure 1 as an example.
FIGURE 1: BID / ASK AND GREEK VALUES FOR THE MAY CALL 135. For illustrative purposes only.
If a market maker buys the May 135 call option at the bid price of $ 5 (he buys at the bid price at which you, the retail trader, sell), he faces three main risks: price ( delta), the temporal decay (theta)), and goes to IV (vega). These are the same risks that the retail options trader must manage.
Usually when you buy an option, a market maker on the other side of the market sells it to you and buys it back from someone else for perfect hedging, while pocketing the gap between supply and demand. . When that doesn’t work, they will rely on synthetic relationships between options to build their hedges, such as creating “synthetic stocks” to offset risk. (See “Improve Your Knowledge of Options: Synthetics and Beyond” in thinkMoney 52.)
If you understand synthetics, you know that the market maker could sell the 135 call synthetically by combining the sale of the 135 put and the sale of the stock. This would cover the trio of top risks, but could also expose the position to early exercise, dividend risk and pin risk.
Another hedging opportunity would be to sell another May call option with a strike price as close to 135 as possible, such as a call of 140 or 130. The trade would become either a short or a long vertical spread depending on strike. The further this trade is from the strike of 135, the less likely it is to reduce risk.
Selling another 135 call in a different, shorter term expiration would turn the trade into a calendar spread and likely reduce delta risk, theta risk, and vega risk. In fact, any additional transaction that reduces any of these risks can be considered hedging. However, keep in mind that you are not looking to eliminate the risk entirely, because without it you are unlikely to make any money.
How do you apply all of this to your options trading in the real world?
What about coverage with the VIX?
It might sound strange, but since option theft premiums rise and fall separately from the price of the underlying assets, you may think of theft as an asset class when you diversify. But can theft, like the VIX, be used to cover your wallet? The simple answer is yes. And no.
If you are running out of iron condors, for example, and want to protect yourself against a rise in market theft (the rise in theft hurts short positions), buying VIX call options could do the trick. case if you think the VIX might rise while you’re in the position. But be careful. VIX options are not evaluated against the current or spot VIX value. Rather, they are priced against the futures value (based on VIX futures contracts), so call options may not jump as expected when the VIX chart appears.
Still, if you choose the right time, buying VIX calls can work as part of an “asset diversification” strategy. Don’t expect to hold the trade for long. VIX options are designed to be a short term hedge, not a long term investment.
It is tempting to fill your portfolio with bullish trades when the market is rising. But even if you are “diversified” in different industries, you will probably lose money if the market goes down. Even in a bull market, not all stocks go up at the same time. When a stock goes up, it may rest and come back part of the time, or it may trade sideways as it consolidates its gains. The same is true when the market is going down, so you may want to consider layering some bullish trades as part of an overall bearish strategy.
You can also reduce directional risk by converting existing long buy or sell long positions to vertical long positions by adding a short option at another strike price. You will still have your directional trade but with less risk. Before adding another long call to a portfolio that already has long calls on other stocks, see if those other positions might be ripe for this type of hedging.
Turning long options into long verticals hedges your directional risk and reduces your risk of time decay (and theft). You can also reduce your overall downside risk of the time before you initiate the trade by buying more time than necessary.
Buying “more” time may seem like the opposite of hedging, but long-term options do not degrade as quickly as their shorter-term counterparts. Over a period of time, you will likely waste less time wasting time with longer term options. If you plan to be in a trade for 30 days, you will reduce wasted time by buying options that expire in 60 or 90 days.
If your trades tend to be long options strategies or have longer time horizons, you will likely be long vega as well. Calendar spreads, for example, are vega-positive transactions that can suffer when the IV drops. But you don’t have to ignore this strategy when the volume is high. You might consider a butterfly spread. This risk profile has a similar positive theta to the calendar, but comes with short vega risk rather than long vega risk.
From a directional standpoint, if you are bullish (or bearish), starting with a long vertical spread rather than a long straight option is a strategy designed to resist a volume crash i.e. when IV drops in an instant, such as after earnings announcements or other expected press releases.
Another risk to watch out for is the overall market volume. The IV of one option may not correlate with the IV of another. But if the Cboe Volatility Index (VIX) is high, IVs overall are likely to be high as well, and now might not be the time to take on long vega trades. Conversely, if the VIX is low, you may be able to avoid running out of iron condors.
Of course, what is high and what is low can be debated. For a long time, a VIX at 20 was considered high, and it peaked around 11 or 12. Sometimes highs were around 30-40 with occasional peaks even higher, with 20 at the lower end. But in 2021, we saw that weakling crackle and give way to a teenage VIX. Does the “normal” range change again? Anything is possible (see “How to spot a new volatility regime”).
Overall, diversification is an important tool, but it is only one tool among many available to you. When markets sell, assets tend to correlate and diversification becomes less effective. When you hedge, you engage in offsetting transactions that can increase diversification and can also be risk reduction tools.
Kevin Lund is not a representative of TD Ameritrade, Inc. The materials, views and opinions expressed in this article are solely those of the author and may not reflect those owned by TD Ameritrade, Inc.