diversification with fewer than 30 stocks, if
each one was in a different sector. You could
also make your portfolio more diverse as
your experience allows, or as interesting investment opportunities present themselves.
T WO CONSIDERATIONS
First, why not simply invest in an index instead of a stock portfolio? An index fund, or
index options like SPX or NDX, for example,
can have lower commissions than investing
in many individual stocks. And yes, a fund
may come close to matching the performance of a benchmark index like the S&P
500 or Nasdaq 100, but you give up some
flexibility. For example, if you think energy
stocks might underperform, and if the index
has significant weight there, you can’t call
up the S&P 500 and ask them to kick out the
energy stocks. But you can remove or reduce
positions in individual equities by managing
a stock portfolio yourself.
Also, when you invest in a single index,
you have less flexibility in choosing strategies than with individual stocks. Maybe you
want to sell some calls against your long
index to reduce your position’s breakeven
point, or generate income in exchange for
limiting upside potential. Index options
often have lower implied volatility (“IV”)
than options on individual stocks. That
makes sense because indices have theoretically lower unsystematic risk than individual stocks. With lower IV, all things being
equal, the option premiums are lower, too.
That means you might collect less premium
when you sell index options.
But if you don’t have much money in your
account, how can you buy a bunch of stocks
to create a portfolio, especially when some
of them cost hundreds of dollars per share?
If you buy 100 shares each of even just a few
stocks, it can add up.
A SPREAD ALTERNATIVE
There’s another possible portfolio path:
option spreads. Suppose you’re trading a
smaller account. Ideally, you’d want a bullish
portfolio composed of long delta positions
in stocks in order to reduce unsystematic
risk through diversification, have flexibility
in choosing stocks or weighting sectors, or
You may remember
astronomer Carl Sagan’s
signature line “billions
and billions” rolling musi-
cally off his tongue. He was usu-
ally referring to stars, galaxies, or something
else equally mysterious in outer space. In
finance, “billions and billions” often refers
to the amount of assets portfolio managers
run. You know: “Joe Schmoe, portfolio man-
ager at Great Big Asset Management, with
X billions of dollars under management.”
This may lead people to think that portfolio
theory is only for Mr. Schmoe and his bil-
lions. Well, not necessarily. Portfolio theory
can be for the rest of us, too—investors and
traders, big and small.
JUS T WHAT IS PORTFOLIO THEORY?
In simple terms, portfolio theory is about
increasing return for a given risk level. Say
you could invest $10,000 in strategy A or B.
Strategy A has a potential return of $500 and
a max risk of $1,000. Strategy B has a potential return of $700 and a max risk of $1,000.
All things being equal, portfolio theory suggests you’re better off investing in strategy B.
For the same level of risk ($1,000), you get a
higher potential return ($700 versus $500).
Then, there are systematic and unsystematic risks. Systematic risk is when stocks are
pulled up or down by the overall market.
Unsystematic risk is company-specific risk
like earnings, news events, corporate uncertainty, and so on. You can reduce unsystematic risk with diversification, but you can’t
reduce systematic risk in the same way.
That’s because theoretically, all stocks are
impacted by the overall market to some extent. You manage systematic risk by allocating your account’s available capital among
stocks, bonds, cash, and other assets. When
you build a portfolio with many stocks, you
reduce the unsystematic risk but maintain
the market’s theoretical return.
How many individual stocks do you need?
If you trade too many stocks, your portfolio
can become unwieldy. You could achieve
employ a variety of strategies depending on
volatility and your personal risk tolerance.
Here are three bullish strategies you
might consider when creating a diverse
portfolio. Capital requirements for these
strategies are typically less than what you’d
need for similar exposure to stock, and they
provide the opportunity to build a portfolio
of 30 stocks or fewer.
A long call vertical is a long call at a lower
strike and a short call at a higher strike in the
same expiration that carries a debit. It’s a
bullish strategy, with a max risk of the debit
paid if the stock is below the long call strike
at expiration; a breakeven price of the long
call’s strike price plus the debit; and a max
potential profit of the difference between the
strikes minus debit when the stock is higher
than the short call strike at expiration, not
including commissions. You might consider
long call verticals as a bullish strategy when
the stock’s volatility (“vol”) is lower.
The debit of a long vertical depends on
the stock’s price. For example, the debit
on a long 200/205 call vertical on a stock
trading at $202.50 might be $260, while
the debit on a long 100/102 call vertical
on a stock trading at $101 might be $120.
You could potentially have a portfolio of
long call verticals in 20 individual stocks at
different price levels, with a total debit (not
including commissions) of less than $5,000.
SHORT PU T
A short put vertical is a short
out-of-the-money (OTM) put and a long further OTM
put in the same expiration that delivers a
credit. For example, with SPX trading at
2,700, a short put vertical might be to sell
the 2650 put and buy the 2600 put with the
same expiration. It’s another bullish strategy,
with a max risk of the difference between the
long and short put strikes, minus the credit
received if the stock price is below the long