Author: Clinton Lee.
Applying a more
complete definition of diversification can help retail option traders diversify
their portfolio profitably, beyond equities.
A buddy started
online options trading from home, in the last 6 months. He was trading a mix of
Verticals, Calendars and Iron Condors using highly liquid Indexes but was
failing to get consistent profits.
Naturally, I asked, “Which Indexes?”
He answered, “DJX,
DIA, MNX, QQQQ, RUT, SMH, SPY and XSP.
I’ve incorporated broad-based Indexing across large, mid and small-cap
stocks to remove single stock exposure.
Having learnt how to trade options with Verticals, Calendars and Iron
Condors, I’m spreading across these various Indexes. I’m being careful with
money management, 2%-5% per trade, I’ve diversified risk, yes?”
No. He has
partially diversified a portion within his portfolio; but, is still suffering
concentration risk. All he has
really done is allocate capital across multiple products, using various option
spread types; yet, all his trading capital is stuck in equities.
In choosing the
MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in
these Indexes: for example, AMAT (Applied Materials) is a component of all 5
Indexes. Bear in mind the MNX and
the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference
being the MNX is an European styled cash settled Index and the cubes (QQQQ) is
an American style stock settled Index.
Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP
- both the SPY and the XSP track the S&P 500, the SPY is American style
stock settled and the XSP is European style cash settled. Duplication is not diversification. Even if you allocated capital to the
smaller versions of the Dow: DJX, the European style cash settled version of
the DIA which is the American style stock settled version. Moreover, if you extended capital
allocation to trade the RUT, thinking you are diversifying into small-cap
stocks and away from large-caps, you just sunk more of your trading capital
into equities. Again, you cannot
achieve diversification by adding more capital in the same asset class. That is concentration risk in stocks.
Do not confuse asset category (market capitalization) with asset class.
Why
bother diversifying across Asset Classes? To answer this question, I’ll use
an example of a well known traded stock:
Apple (AAPL). You won’t
need to understand Fundamental Analysis to follow the reasoning.
Summarizing a financial extract from its Annual Report, Apple has almost
~30% of its Net Sales distributed across: UK, France, Germany, Spain &
Ireland and Japan. Apple’s
customers in Europe are paying in EUR/GBP and customers in Japan will be paying
in JPY. Even though you are
trading Apple directly as a US parented firm listed in the US and the currency
of the parent is USD denominated, the company has currency exposure to the
EUR/GBP and JPY arising from operating sales entities in those
jurisdictions. So, you are already
exposed to currency and geographic risks by choosing Apple as a product to
trade, even though you are constructing an option trade on the stock.
So, it makes sense, rather than have these exposures wrapped inside the
stock, where you are subordinating non-equity risks to the stock, to deliberately
surface the risks in Geography, Commodities and Currencies. Then, isolate these elements and trade
them directly using optionable Geographic ETFs, Commodity ETFs and Currency
ETFs.
Is there an example of a consistently profitable and diversified
portfolio to see the merits of trading options beyond equities? Yes. View Consistent Results to learn how to trade options using a multi-asset class
set up. Notice how the profits
step up gradually, from the mid hundreds to the higher hundreds; then, from the
higher hundreds into the thousands.
While, the losses are contained within the mid to lower hundreds. Diversification to trade options in
non-stock asset classes using Geographic ETFs, Commodity ETFs and Currency
ETFs, deliberately dilutes the concentration risk in the portfolio’s P/L.
If you are puzzled, yet intrigued, you may well ask, “I don’t need to
Beta-weight the Deltas of my option positions; then, hedge using Futures? Do I need to adjust my existing
positions by embedding single options; or, morph the original spread into a
hybrid option strategy?”
No, is the answer to both questions. Just as it would not make sense
within stocks to say Beta-weight a company like GE to the SMH (Semiconductors
Holdrs), there is even less sense to Beta-weight a broad-based Index like the
SPY to an Emerging Market ETF, Commodity ETF or Currency ETF. Diversification is designed to break
the commonality in correlation between the asset price movements of products,
in the retail trader’s portfolio structured for online options trading. Adjustments fail to provide the
consistency in laddering up the profits as seen in the portfolio, because an
adjusted trade often fails to restore, let alone improve the original profile
of the trade’s volatility and probability that was bought or sold.
How is this possible? Volatility can be added to/reduced from the
portfolio, as not all Asset Classes or Sectors or Individual Companies or
Countries move up/down in value ALL at the same time; and/or, ALL at the same
rate. It is the volatility level
across various asset classes that is targeted for diversification.