How to Reduce Portfolio Risk with Options Diversification
These three lesser-known forms of diversification can keep any one position from causing too much pain
How to Reduce Portfolio Risk with Options Diversification
"It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket." - "Don Quixote" by Miguel de Cervantes
This passage, written almost 500 years ago, became a bedrock principle in business and finance. As investors, we keep from putting all our eggs in one basket with tactics of diversification.
Odds are you already own an index fund or multiple stocks in a portfolio, possibly multiple assets like bonds. This is classic diversification and what most people think about when you ask them about the concept.
Yet, diversification isn't limited to stocks or bonds.
You can apply it to any investment strategy to reduce position-specific risk.
And yes, this can include options strategies as well.
Let's look at three ways you can arrange options that should reduce the risk of any one position causing too much pain if it goes against you. Then, I'll show you how to program these strategies into your TradeSmith Screener so that the new ideas it gives you are diversified in these ways.
Chances are you already know these methods but never thought about them as ways to diversify your options trading – until now.
Method No. 1: Diversify By Expiration
In the bond-investing world, there's a strategy known as "the ladder."
Quite simply, portfolio managers will split their capital up amongst bonds with different maturity dates, which reduces interest-rate risk.
We can do something similar with options, keeping in mind the two components of an option price: intrinsic and extrinsic value.
Intrinsic value is the option's theoretical price that we'd see if it were at expiration right now. For example, if I owned a call option with a $100 strike price and the stock was trading at $101, that option would have $1.00 of intrinsic value.
The remainder of the option's price is made up of extrinsic value, which is essentially just the time value of the option between today and expiration day.
Extrinsic value is like an insurance premium that increases or decreases based on demand (calculated as implied volatility) as well as the distance between the option strike price and the stock's current price given how much time is left until expiration (time value).
As your option approaches expiration, its extrinsic value declines exponentially, as shown in the graphic below, which is why we need to factor expiration dates into our diversification.
You can see above that an option contract – put and call alike – will lose the majority of its extrinsic value in the last 30 days before expiration.
So, to diversify, you can craft a portfolio of options with different expiration dates, just like a laddered bond portfolio with different maturity dates.
Given that the option's price gets more sensitive to the underlying stock's movement closer to expiration, you want to have some positions with high, low, and medium sensitivity. So, a good way to diversify is by spreading out your positions across multiple expirations.
This keeps time decay from hurting you, although it also keeps it from helping you. At TradeSmith, I and my colleagues John Jagerson and Wade Hansen of Predictive Alpha Options generally prefer to act as sellers of options, aiming to collect income upfront, especially with options whose expirations are coming up soon. This actually puts time decay in our favor.
Now, let's discuss the second way to consider option diversification.
Method No. 2: Diversify By Direction
This next tactic is a lot like the hedges that fund managers will hold against their portfolio of stocks. The last thing a fund manager wants to tell their clients is they weren't prepared for a market crash.
Think of Cathie Wood and her tech-heavy ARK Innovation ETF (ARKK). She might be inclined to buy puts on the Nasdaq 100 to remove some tech-sector-specific risk in her portfolio.
As an options trader, you can hedge a bullish position with a bearish one and vice versa. So, if you owned a lot of call options, you could buy puts on an index ETF to offset some of your risk.
Likewise, if you owned a lot of put options, you could buy calls to offset some risk.
For those of us who like to sell puts but want to reduce risk, we could buy puts against a market index to hedge against the possibility of a sharp market decline, perhaps buying put options on the Invesco Nasdaq 100 ETF (QQQ).
When it comes to thinking about options, there's yet another way to diversify that you should consider.
Method No. 3: Diversify By Type
As I pointed out earlier, the extrinsic value of an option declines over time. If I'm an option buyer, this works against me. But if I sell an option, this works in my favor.
So, I could sell a call to offset bullish positions or sell a put to offset bearish ones. The idea is to reduce the impact of time decay, whether for or against you.
In fact, that's the entire premise behind nearly all option spread trades: They reduce risk by taking a second option position on the same stock that's directionally opposite of the first.
Now, let's take what we've discussed here and put it into action using TradeSmith tools.
Uncovering Opportunities
One of my favorite tools for diversifying my options portfolio is the Options Opportunities in TradeSmith Finance.
Simply log in, click on Options from the top menu, then Opportunities, and click the Strategies dropdown menu.
This prepopulated screener, shown below, narrows the focus of our traditional options screener, making it easier and faster to locate ideas in a particular style – in this case, fitting our diversification tactics.
Members with Options360, TradeSmith Essentials, or TradeSmith Platinum can find trades like this every day using our Options tools within their platform. (And if you don't see these tools in your TradeSmith Finance dashboard — and would like to — call 888-623-0858 to discuss.)
What I love about this tool is I can specify the Days to Expiration and the Strategies so that they fit our diversification plan.
First, by option type:
Buy Calls
Buy Puts
Buy/Write Covered Calls, etc.
Then I can specify which stocks I want to look at or select from Newsletters Recommendations, TradeSmith Baskets,Predictive Alpha Options Zones, and more.
Mike Burnick's Bottom Line: Here's one final tip when it comes to exploring options diversification strategies: If you're new to this, start with just one parameter. Get comfortable with it before moving on to the next one. And it won't take you long to master each by using the powerful TradeSmith Options Opportunities tools. Pretty soon, you'll be diversifying your portfolio like a mini hedge fund manager.
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