Think back to 2008, when stock prices crashed. Bonds moved up initially as
stocks dropped, but then bonds dropped,
too. When bonds drop at the same time as
stocks, they’re not a great hedge. Sure, you
could have sold bonds when they peaked
and reallocated into cash, but who has that
foresight? Being able to catch the right side
of big moves can be as much a matter of luck
as skill. And if you’re adjusting your percentage allocations every few months or years,
are you nimble enough to take advantage of
potential shorter-term opportunities?
A trader might have an approach that
adds agility to her portfolio. No, we’re not
saying you, the investor, should turn into a
trader. Rather, analyze what a trader does so
you become a more informed investor. The
trader’s three primary concepts to manage a
portfolio—delta, capital requirements, and
return on capital—are what you might like to
consider. Let’s see how.
GOTTA LOVE CHANGE
Delta is the amount an option’s price chang-
es when the underlying
stock or index moves $1. But
that delta can be extended
to your entire portfolio
through beta-weighting on
the thinkorswim® platform
from TD Ameritrade (you’ll
find a detailed explanation in thinkMon-
ey 36). Beta-weighting converts deltas of
individual positions into beta-weighted
deltas in some common unit—like the S&P
500—so you can look at your portfolio’s risk
from an “apples-to-apples” point of view
(even though it contains grapes, oranges,
Like an investor, a trader will look at the
total beta-weighted delta of her portfolio
to assess overall risk. But she’ll also look at
each position’s delta to see if one is much
bigger or smaller than the others. That could
indicate excess risk in one security where
she doesn’t want it.
Say you have 300 shares each of various stocks. But the deltas have been beta-weighted to the SPX, which shows that
in SPX terms, FAHN has more deltas than
GVRC. A trader might decrease the deltas
in FAHN by selling some shares, buying a
collar (buy a protective put, sell a covered
call), or selling covered calls. Or she might
increase the deltas in GVRC by buying
shares or shorting puts.
Having relatively balanced beta-weighted
deltas could help diversify your positions
and potentially reduce unsystematic risk.
Traders never know which trade could be a
loss, and they don’t want an oversized position to take them down. Investors probably
don’t want that either.
IT’S GREAT TO HAVE FUNDS
To execute a trade, you need a certain
amount of capital (i.e., money) in your
account. How much capital you need depends on the trade(s) and type of account
you have. Some trades in certain underlying
stocks have bigger capital requirements.
Some have less. Explore how much capital
an individual position requires on the
Position Statement section of the Monitor
tab on the thinkorswim platform.
The BP effect, or buying power effect, is
the impact a position has on an account’s
available trading capital, or buying power
(Figure 1). With naked short option positions, the BP effect is negative, and it’s easy to
see how much capital one position is using.
If you see that one position uses more capital
than the others, you might consider reducing
that stock’s position, or hedge it so that its BP
effect is more in line with the others.
Making sure the capital requirements of
your positions are relatively equal means
you’ll have an idea of how much you’ll need if
you want to increase an allocation into equities or bonds, or how much capital you might
free up by closing certain positions.
THETA RETURNS? HMM …
Return on capital is a way to think about
how much a trade could potentially make
relative to its capital requirements. Now,
Stock, bonds, cash—that’s an investor’s standard menu.
You put, say, 70% of your money in stocks, 20% in bonds,
and 10% in cash. The assumption is that stocks and bonds
are somewhat uncorrelated, meaning they don’t move up
and down at the same time. If stocks crash, bonds might go
up, and vice versa. And cash will just stay cash. You make
adjustments to the percentages depending on your market
outlook. Maybe you do that
every month, or every quarter,
or less often. And you think
you and your portfolio are set.