If you beta-weight the positions to a common index,
is there a particular symbol that has a much bigger
delta than the others? That means that your portfolio’s
risk is concentrated in that one symbol. (See sidebar,
“Bet Your Bottom Beta.”) It’s okay to have a stronger
bullish bias on a particular stock, but make sure you
understand the risk it presents to your portfolio. If that
one stock crashes, it can wipe out all your other gains.
REMEMBER THE BAD OLD DAYS, WHEN INVESTORS
just bought a single stock and hoped for the best? Then
came the ’80s, when star mutual fund managers sold
us on the benefits of “diversification”—particularly the
diversification that came from their funds. So then
investors bought a couple funds and, once again,
hoped for the best.
Diversification for a stock portfolio is a way to
reduce “non-systematic” risk. Systematic risk is the
danger of the whole market dropping and all stock
prices falling along with it. Non-systematic risk is the
danger that is unique to a specific stock, such as management skill, products, legal rulings, and so on. The
idea is if you have enough different stocks in your portfolio, all those company-specific risks offset each other,
and no single risk will dominate your portfolio.
All that’s fine. But when you’re a floor trader standing in a trading pit that’s only trading options on one
index or stock or future, diversification across different
underlying securities isn’t really possible. So, you think
about diversification in a different way. Different
spreads have different risks—some lose money when
the stock goes up; others, when the stock goes down.
Some lose money when volatility goes up; others,
when volatility goes down. Retail option traders and
investors can trade any stock or index they like, but
they can still benefit from thinking about how an
option trader might diversify. Let’s look at a few different approaches.
HEDGING TIME AND VOL
If you do have any options in your positions, you’ll
notice other greeks in addition to deltas—theta and
vega in particular. While stock trading is somewhat
one-dimensional—stocks only go up and down—
option trading has to contend not only with the stock’s
movement (delta), but also with changes in volatility
(vega) and time passing (theta). An option trader can
be right in picking the direction of a stock, but be
wrong on time and volatility—and lose money. That
means that the trader who ignores all the factors that
affect options could be blind-sided by any one of them.
Earlier, you looked at delta. Now look at vega—do
all your positions have either positive or negative vega?
Negative vega means your positions are losing money
as implied volatility drops, assuming no change in the
stock price or theta. If every position has positive vega,
what happens if volatility drops? You should look at
theta in the same way as well. Are all your positions
negative theta, which means your option positions are
losing money as each day passes (assuming no change
in the stock price or volatility)?
Just because all the deltas, vegas, and thetas are
“pointing” the same way isn’t necessarily bad, as long
as you understand the risks. If you are very confident
in the direction of stock prices or volatility, then perhaps your portfolio is appropriate. But if you’re not too
confident, and I don’t know many traders who are,
then you might want to diversify a bit. Different option
strategies such as verticals, calendar spreads, and iron
condors have different delta, vega, and theta characteristics, so it’s a good idea to learn more about them.
(See “Five Strategies under $1,000,” thinkMoney, Summer 2009.) Diversification with options comes from
mixing them so that the portfolio has the delta, vega,
and theta risk that you’re comfortable with. No single
risk should dominate your portfolio.
First, let’s look at the net risk of your positions. Right
now, go ahead and launch your TOS trading platform
and look at the Position Statement section of the Monitor page. You can see that each symbol’s net position
greeks are displayed. (You can do this exercise whether
or not you have option positions, because even stocks
and mutual funds have delta.)
Are the net deltas all positive? That means you want
them all to rise—at least a little bit. What happens if
the market falls?
BE A NIMBLE STRATEGIST
As a market maker, I didn’t diversify with a particular
trade in mind. Rather, as orders would come into the
pit, I would think of them as either increasing or
decreasing the risk of my position. If I wanted to
decrease the risk, then I might be a little more aggressive in making a market for an order that would do
that. I was willing to give up a bit of theoretical edge to
get my risk in line. For example, if my position was
overall positive or long vega, and I wanted to make it
less positive, then when an order came in to buy a calendar spread, I would make my offer a bit lower to try
to sell it. A short calendar has negative vega, so if I sold
it, my overall vega would become less positive.
As a retail trader, you can’t really do that because