Lesson Objective: Learning the importance of (1) diversification when trading options and (2) benchmarking your portfolio
1. The Diversification Dimension When Trading Options
You may have heard the expression “Diversification is the only free lunch in finance” coined by Nobel-prize winner Harry Markowitz, the father of the Modern Portfolio Theory (MPT). The idea is that by diversifying his/her portfolio, an investor gets the benefit of risk reduction without losing in returns.
Unfortunately, correlations have increased since Markowitz’ publication of MPT in 1952 due to a more globalized world. However, even during periods of market corrections where correlations typically increase significantly, they do not go to 1 (i.e., they do not become perfect) so diversification still provides benefits.
Numerous studies and mathematical models have shown that maintaining a well-diversified portfolio offers a cost-effective level of risk reduction while maintaining or even improving overall returns. This is due to the fact that a specific asset class will rarely be the best performer on a long-term basis, or even on a short-term basis for that matter. If you visit the website Portfolio Visualizer, you will notice that for almost every single year since 1986 the best performer has never been the same asset class.
Very few people (including finance professionals or so-called experts) can beat the market and have the ability to successfully forecast which asset class will be the best performer this year, let alone any other year. Of course, if you had a crystal ball and were able to pinpoint the winner for 20 years in a row you would probably be at the top 0.001% of portfolio managers and could argue that diversification is more of a detriment to your performance than a valuable risk-management tool.
However, most of us are unable to predict what the next sequence of best performers will be.
According to the 2018 S&P Dow Jones Indices’ famous annual SPIVA U.S. Scorecard research (S&P Indexes Vs. Active management): “Over the long-term investment horizon, such as 10 or 15 years, 80% or more of active managers across all [equity] categories underperformed their respective benchmarks” and “the longer-term 15-year figures show that most active fixed income managers underperformed their benchmarks.”
Therefore, in the vast majority of cases you are better off diversifying your investment or trading activity over a number of asset classes.
In most people’s mind, the concept of diversification translates into holding or selling financial instruments across various asset classes. As options are derivative products of such instruments, it is logical that they would benefit from a diversification approach as well.
In other words, according to the principles of diversification you should be better off trading options on underlyings from different sectors, industries, geographical focus, or asset classes than by trading options on a single underlying (assuming you employ the same strategies). For instance, trading options on SPY and FXI (China Large Cap ETF) has a correlation of 0.69 vs trading on SPY options alone, at the time of writing this lesson module.
However, be aware that in the case of options, you will need to account for the depth and liquidity of existing contracts (for which the bid/ask spread is the leading indicator). The diversification opportunities are likely to be narrower than in the equity or bond markets since many underlying instruments do not offer options with tight bid-ask spread or any options at all. So, you must make sure that your quest for a “free lunch” does not result in other expenses (eg., fees or opportunity costs) which outweigh the diversification benefit.
In our case we believe that using options themselves (such as married puts) can be more efficient than diversification because of the adverse correlation effect during times of market stress as discussed above. In any case you should only diversify within your risk appetite. This means: do not diversify into positions of sectors you don’t believe in for the sake of diversification. You should always select underlyings, industries, sectors, or geographical areas that you are keen to explore and own, and then try to diversify within these parameters. If that isn’t possible, then consider holding more cash on the side for better times or use options to hedge some of your exposure.
It is also worth mentioning that in the case of options, diversification can also be applied at other levels than through the underlying itself.
As you will see when we go through the next lessons, there are many types of option strategies. Their names often convey the intent associated with trading them. For instance, if you sell a BEAR Call Spread, it means that you are usually bearish on the underlying. Conversely, if you buy a BULL Call Spread, you are most likely bullish on the underlying. And for each sentiment or view you may have on a specific stock, or sector, you have an array of options to choose from (pun intended).
Option strategies themselves can be an effective diversification tool and that’s the reason why you should first learn all of them, understand their key attributes, their main differences, their advantages and drawbacks even if you end up employing only a handful of them as you gain more expert knowledge and shape your trading style and preferences.
By diversifying your strategies, you can fine-tune the response of your overall portfolio to market movements and better manage your exposure according to your risk appetite. You can also better align yourself and (re)balance your portfolio with the market if you so wish or with another benchmark of your choice.
2. Benchmarking Your Portfolio
As you probably know, most securities, mutual funds, ETFs, investment portfolios, or other trackers will compare their performance to that of a benchmark (e.g., the S&P 500 for large cap equity (SPX), the Russell 2000 for small-cap (RUT), the Barclays Agg for U.S.-based investment grade bonds, and the MSCI EAFE Index for international funds).
We are big proponents of benchmarking your trading activity, even as an individual. Not only will this give you a chance to evaluate your performance but it will also force you to analyze the strategies and pinpoint the ones that have been working well for you and the ones that have been problematic. It will help you become a better, more astute trader.
However, a benchmark is only relevant to the extent it is representative of your actual holdings and trading style both in terms of underlying but also in term of risk profile (see example below).
This is no different for options. For instance, if you mostly trade options on SPY (the S&P 500 ETF), what is your performance (return) in comparison to the performance of SPX? If 50% of your options are on IWM (The Russell 2000 ETF) and 50% are on SPY – how do you compare to a benchmark made up of 50% SPX and 50% RUT for instance? And, equally important, how do the risk profiles compare?
There are thousands of possible benchmarks available in the financial world (like the multitude of sector-specific SPDRs or “spiders”), so no matter what the composition of your strategies, you should be able to find a meaningful benchmark or build one of your own as illustrated above and further down below in the examples.
We do not believe that having a benchmark that is a 100% match is essential, the idea is to identify the most relevant one for your portfolio. Above all, you will have a beacon to guide you and to help you fine-tune your strategies.
Once you have identified or created a relevant benchmark, you need to re-balance your trading activity so that it is in line with your benchmark and/or define a new benchmark if you decide to make significant changes to your portfolio. Benchmarking is a dynamic process that needs to be used on a continuous basis, and updated often.
Why not take a couple of examples to illustrate the concepts we have just discussed.
Example A:
Let’s assume that you are currently bullish and you have chosen the Dow Jones (DJIA) as your benchmark since you mostly trade options on DIA (the ETF version of the Dow Jones). You also trade many of the stocks included in DJIA (such as Apple, Coca-Cola, IBM, or Procter & Gamble). Assume that you start with a $10,000 portfolio and the following scenario:
One month ago, when DIA was at $235, you bought one two-month call on DIA with a $240 strike for $4 (total cost $4 x 100 shares = $400) and you set aside the rest of your portfolio in cash (i.e., $9,600).
Now DIA is at $255 and the value of your option is $16.5, which you sell back to the market for total proceeds of $1,650 (disregard commissions). So, over that one-month period of time, DIA’s performance is +9% (255 vs. 235) while your performance on the option alone amounts to +313% ($16.5 vs. $4) i.e., 36 times better! Sounds great so far.
However, you have to factor in the fact that $9,600 was in cash (and earned a negligible interest). So, the total value of your portfolio after one month is actually: $9,600 + $1,650 = $11,250, i.e., a +12.5% performance ($11,250 vs.$10,000).
You could then be tempted to compare this 12.5% gain with the 9% gain for DIA but the 9% assumes that all $10,000 would have been invested in DIA. Note however, that your maximum risk was only $400 at all times (i.e., 4% of your portfolio value) – the premium paid – not $10,000 (which would have been your maximum amount at risk if you had invested all of the portfolio value in DIA). Consequently, the two portfolios do not share the same risk profile and you would not be comparing apples to apples.
As you can see, you need to always factor in the risk profile of your portfolio vs. that of your benchmark in order to make a sensible comparison.
Using DIA alone as the benchmark for your portfolio was not appropriate here. Instead, you should consider a “made-up” benchmark composed of 4% DIA ($400/$10,000) and 96% one-month Treasury bill. This would better reflect the portfolio’s risk profile.
The performance of such a benchmark over the one-month period would have been 0.36% (9% x 4%) (we assume the performance of a T-bill to be negligible here).
Given the significant gain on your call option, you would still have beaten the benchmark by 35 times. Note however, that this is less than the 36-fold number seen above. This is due to the cash position that has now been reflected in the equation. Hence, the importance of considering the actual composition and risk profile of your portfolio vs those of your benchmark for optimal relevance.
Remember that your benchmark will need to be adjusted as the assets in your portfolio change as it is a dynamic process.
Example B:
Now assume that your $50,000 portfolio is comprised of $25,000 in cash, and $25,000 invested in SPY (you are long the S&P 500 ETF as you believe the market will go up over the long-term). This is a bullish make-up since you gain when SPY goes up.
According to what we have just discussed above, your benchmark should be tailored to your assets i.e., a basket of 50% US Treasuries (assuming you hold your cash in the United States) and 50% SPX (S&P 500 Index) to reflect the risk/reward profile of your current portfolio.
Further assume that your views now change and you are neither bearish nor bullish on the broad US market for the short-term as you are not sure where it might be going for the next month or so.
Obviously, you need to adjust your portfolio so that it becomes “delta-neutral” to reflect your new sentiment. Delta-neutral is a technical term usually used for options that we will discuss in detail in the lesson on Delta – it basically means that you are making money if the underlying under consideration moves sideways, i.e., stays close to its current level, or that you are indifferent if the underlying goes up or down, for instance if you are all invested in cash.
Let’s continue by assuming SPY to be at $250 which implies that you are holding 100 shares (25,000/250). Therefore, an increase of $1 in the price of SPY, would increase the overall value of your portfolio by $1. On the other hand, a decrease in SPY by $1 would decrease your portfolio value by $1. To be delta neutral you need to modify your portfolio so that the $1 increase/decrease is neutralized.
One solution would be to use some of your cash to buy SPY puts (a bearish position) with a $250 strike so that a $1 increase in SPY would be offset by a $1 decrease in the value of the SPY puts you hold.
In the lesson on Delta you will learn that an at-the-money (ATM) option contract (representing 100 shares of underlying) behaves like having $50 shares of the underlying at the time you trade the option (delta is 50). So, buying 2 ATM calls is equivalent to buying 100 shares of the underlying at time of entry. Similarly, buying 2 ATM puts is equivalent to selling 100 shares of the underlying at time of entry.
In the example above, you would therefore buy 2 put options with a $250 strike: if SPY goes up by $1, your SPY shares go up by $100 while the value of your option contracts go down by $100 (to illustrate the concept here we will assume that the other option factors such as volatility or time decay do not vary significantly). Conversely, if SPY decreases by $1, so do your SPY shares, but the move would again be mostly offset by the value of your option contracts going up $100.
As you can see, by entering options you can maintain your bullish long-term view on SPY but temporarily factor in a change of sentiment in the short-term. You can keep using, rolling and adjusting these put options to neutralize any upside as long as you believe the market is uncertain.
Note that you will need to adjust your benchmark to factor in the new portfolio construction as (1) you used some of the cash to buy the puts, and (2) you now hold long puts on SPY in addition to your long SPY position.
Example C:
Finally, assume that you are neither bullish nor bearish on the overall market again, but this time your portfolio is comprised of only two SPY option contracts (a short call and a short put) with the same expiration date and $250 strike that you sold when SPY was at $250 (such a combination of a call and a put is called a “Straddle”).
So, if SPY goes up, your short put makes money but the gain is largely offset by the change in value of the short call that loses money, and vice-versa. Essentially, you are delta neutral at time of entry. Given that all your portfolio is based on SPY, SPY will serve as your benchmark.
Suppose SPY increases to $260. Given that your strikes are centered at $250, your portfolio is now bearish (i.e., you make money if SPY goes down, and lose more if it goes up). This is due to the fact that for every $1 increase in SPY, the short put will be further out-of-the-money and will gain less money than the loss you will suffer on the short call.
Because SPY is your benchmark and your view on the market is neutral, you need to adjust your portfolio so that it “resets” to a delta-neutral status. Since your portfolio turned bearish you need to enter into a new straddle, bullish this time. You could consider a strike at $270 for instance. You will learn the options that are available to you when we go through the lessons on different strategies.
As you can see, it is essential that you have a clear idea of your views/sentiment of the underlying on which you are trading options as well as the benchmark that will be most appropriate to gauge your performance. This will help you analyze whether or not you are successful in actively trading a specific underlying and/or strategy vs. a buy-and-hold approach. It also forces you to understand and focus on the risk profile of your overall portfolio and make timely and appropriate adjustments.
The benefits of diversification and benchmarking your portfolio cannot be overstated and should be dynamically re-assessed on a regular basis, according to rules that you will have established as part of your overall trading plan. This may save you hundreds, thousands, and hopefully millions of dollars.