OAP 078: Is Your Investment Portfolio Unbalanced? 4 Ways To Fix It & Get Back To Neutral

Download The "Ultimate" Options Strategy Guide

I know one of the key elements to successful options trading long-term is maintaining an investment portfolio that is consistently balanced. And when I talk about balance, I'm not talking about 80% stocks and 20% bonds - that's portfolio diversification. Unlike traditional investment strategies that favor 99% of the portfolio invested in long equities and bonds with minimal short exposure, what I'm specifically referring to here is the concept of trading a mix of bullish, bearish and neutral positions all the time which gives us a much smoother and solid equity curve.

One of the best ways to measure overall portfolio balance is to beta-weight the portfolio to a benchmark index like the S&P 500 (SPX or SPY). This metric gives us an apples to apples look at how the portfolio as a whole would perform when the market moves higher or lower. And once you start monitoring the beta-weighted portfolio you'll notice that sometimes your positions can become unbalanced and lopsided.

In today's podcast, we'll give you four option strategies or techniques we use to help re-balance a portfolio that's gone out of wack. Of course, having a completely delta neutral portfolio is always the goal, but never the destination, and our talk about maintaining balance and neutrality should help as you continue adding and adjusting your option trades this year.

Key Points from Today's Show:

  • One of the keys to being successful in trading is having a balanced portfolio and making sure that you positions are neutral around the market.
  • When you have balance and neutrality around the market, creating a much smoother equity curve.
  • However, as long as you are trading with 70% chance of success, you should hit 70% or more over time, regardless of where your portfolio is set up.

Example:

You could make all of your trades directionally bullish, and as long as you are trading with 70% chance of success, you should hit 70% wins over time. This applies when making all your trades directionally bearish as well. However, your equity curve will not be as smooth as if you were to trade both sides of the market.

Why Have A Balanced Portfolio

  • Trading both sides of the market helps give your portfolio a smoother equity curve.
  • If you only trade one side of the market, it will create big swings in your account.
  • Avoiding these big ups and downs with a balance gives you greater confidence in your portfolio.

What Does Perfect Balance Look Like?

  • There is no such thing as a perfectly balanced portfolio.
  • The goal is to aim for a Delta neutral portfolio but never actually achieve it.
  • When you have a Delta neutral portfolio and it is exactly balanced to the market.
  • This causes your positions to move every time the market moves.

What is Considered Unbalanced?

  • The easiest way to check for unbalance is to use beta weighting, creating an equity beta-weighted portfolio curve in your broker platform.
  • An unbalanced portfolio occurs when the market is trading very close to one of your break-even extremes.
  • At that point, you have to make adjustments to get it back to neutral.

Four Ways To Fix An Unbalanced Portfolio.

1. Add More Neutral Positions

  • Adding more neutral positions — iron condors, iron butterflies, straddles, strangles — raises the whole portfolio vertically.
  • This pushes your equity curve higher, and as the market moves your portfolio moves and becomes more neutral around the market. 
  • This is a longer-term strategy and requires you add many new positions to rebalance your portfolio.

2. Add Directional Credit Spreads

  • In the case of being too bearish, add put credit spreads to start making money if the market goes higher.
  • This starts to shift the risk away from bearish trades and more towards bullish trades.
  • Likewise, if your portfolio is too bullish, add call credit spreads to even out your distribution curve.

3. Add Directional Debit Spreads

  • This adds a much more rapid inject of transfer of risk in your portfolio, rebalancing your portfolio much quicker.
  • Directional debit spreads are the quickest way to facilitate the adjustment to your portfolio.
  • The directional debit spread is generally added at the "at the money strikes".

Example:

If the stock is trading at $100, you are adding the $99/$101 call debit spread. You are buying the $99's and selling the $101's, and if the market starts moving higher you immediately start making money.

4. Use Skewed Calendars and Diagonal Spreads

  • This can be done during low implied volatility, which is generally when these work better.
  • Trade these skewed calendars and diagonal spreads in the direction of where you want to make money if the market moves.
  • Calendar and diagonal spreads make money at a slower pace, and slower to react to market movements.

Example:

If your portfolio is too bearish and you will already make money if the market moves lower, you need to add positions that give you an opportunity to make money if the market moves higher. Call calendar spreads will be added and placed in the direction of where the market might move higher — above the market or above some ETFs in case they rally higher.

*Do not need to do as many debit spreads or calendar and diagonal spreads because just the fact of staying active and adding positions every week will naturally adjust as the market moves up or down.

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy ?

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Sam Gomez

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week's question comes from Sam who asks:

If you have a $100K account and investing $25K in options, is there a reason you need to leave $75K in cash in your investment account? Could you invest that $75K into something else instead?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

I'm humbled that you took the time out of your day to listen to our show, and I never take that for granted. If you have any tips, suggestions or comments about this episode or topics you'd like to hear me cover, just add your thoughts below in the comment section.

Want automatic updates when new shows go live? Subscribe to the Option Alpha Podcast on iTunes, Google PlaySoundCloud, iHeart Radio or Stitcher right now before you forget - it's fast and easy.

Did You Enjoy the Show?

Please kindly consider taking just 60-seconds to leave an honest Review on iTunes for The Option Alpha Podcast. Ratings and reviews are extremely helpful and greatly appreciated. They do matter in the rankings of the show, and I read each and every one of them!

Also, if you think someone else in your social circle could benefit from the topic covered today, please share the show using the social media buttons you see. This helps spread the word about what we are trying to accomplish here at Option Alpha, and personal referrals like this always have the greatest impact.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he’s a Full-time Options Trader and Real Estate Investor.

He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.