There's no doubt that diversification is important when building an options portfolio. But we need to focus on diversifying the underlying securities that we are trading vs the strategies we deploy, since we know that we make the most money trading as net option sellers.
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In this video, I want to talk about building a diversified options portfolio. So there's no doubt that diversification, on any level helps reduce risk, it also helps reduce profit potential to some degree just to be fair.
In fact, a famous Buffet quote he once said was " Diversification is a protection against ignorance. It makes very little sense to those who know what they are doing." So since don't diversify on our strategy meaning we are net options sellers, and we do that.
That is a targeted strategy for obvious reasons because we know we have an edge there. We need to reduce then risks, where we are ignorant and do not have a reliable edge, and that's what I think the difference, hopefully between a good trader, and a bad trader.
Is a good trader might know exactly where his edge is, and focus all his attention there, and then help reduce risk in places where he has no edge. Meaning for us that's stock picking, so we want to have as much possible diversification, as we can in the number and type of underlined securities, we're trading options on.
Because again we know that our edge is implied volatile, it's in selling options, long term. It is not in picking the direction of stock, that's why we always try to be as neutral as possible, that's why we're always selling options with high implied volatility.
That's why we talk very, very little about the benefits of directionally getting a stock right or wrong. So the reality is that we want to be as uncorrelated as possible, meaning we want to look at all these different asset classes, industries, sectors, whatever you want to call them, and we want to be as uncorrelated, with our trades as possible.
Meaning we want to have a lot of trades on that don't have any relationship to another. For example, if you look at this chart here, you can see that anything in the oil sector, has very little correlation with anything in consumer staples, okay.
So if we had 2 trades on 1 in the oil sector or an oil ETF, and another in consumer staples, they really would move kind of independently of one another. Meaning that if consumer staples went up, oil might go up, or it might go down a little bit, but its not going to be dragged in one direction or the other, by the other industry.
Verses if you look at something like industrials, or the industrial sector, and consumer discretionary, you can see that there's a high correlation or almost a one to one correlation between those 2 sectors. So if we're making 2 trades in consumer discretionary, and industrials, then there going to have a high correlation of moving together, in the same direction.
Does that mean that we can't make a trade there no, it just means we have to be aware, that there's going to be a high correlation, between these 2, and this is a great little chart to use its over from our friends at Bespoke? On all these different correlations over the last 10 years, from these different industries.
Now the truth is that diversification for us, is a never-ending process, it is a goal, it is not a destination. There is no perfectly diversified portfolio, and there never will be an unlimited amount of uncorrelated securities. Even going back to our chart here you can see, there is not one single sector, that is totally 100% not correlated with something else.
Everything has some small correlation, negative, positive, it might be very small but everything is correlated with one another, and our goal is just to mix up the number of trades in the sectors, and industries, that we're trading the ETFS, the stocks, etcetera, and the directions because that is where we don't have our edge.
We want to make sure we're selling options across the board as much as possible, but we want to mix up the securities that we're trading on. So again balance and diversification is always a goal but a constant moving target.
Meaning that as soon as the market trades and starts moving, then it's always going to be a moving target. You just have to recognize that. In our opinion, we think beta is waiting, as we talked about previously helps focus our attention, on the overall portfolio versus single options.
Because beta is waiting takes all of these different industries, and makes them relevant to ETF, or index that you're focusing on, that you're using for your beta waiting.
So now it kind of brings everything together, and says okay, look if my basket of portfolio, you know if I have gold, and industrials, and consumer staples, and financials, or whatever the case is, what does that look like brought together, if it was one big S&P 500 position, or one big you know DIA Dow Jones position? Or whatever the case is.
So that's why we like to use portfolio beta waiting because it helps kind of focus and hone in our attention on what we should be doing. So common questions I wanted to go through real quick. First is everyone always asks what if I can't find good trades in different industries, sectors, or asset classes?
Now the reality is that sometimes industries will fall into in our favor. Meaning that at certain times during the year maybe oil and metal stocks, might have high implied volatility, and therefore those are the best trading vehicles.
Then later on it'll be financials, and then later on it'll be utilities, or whatever the case is, or technology Okay so not everything will have great implied volatility all year so you can evenly trade, all of these different asset classes.
So our response to this question is that you have to target still whatever has the highest implied volatility, and if Let's say that, that sector right now is financials, and only the financial sector has high implied volatility.
Then what you want to do is, you want to diversify within financials as much as possible. Okay, because you still have to trade sure premium, that's still our edge, that's where we need to focus our attention.
But within financials maybe you trade JP Morgan, bullish, and you trade Bank of America bearish, okay so you try to diversify the stock that you're trading JP Morgan, to Bank of America, and you try to diversify the strategy, you trade one a little bullish, you trade one a little bearish, you're still selling Options Net, you still have a wide area for margin for area for trades.
So you just have to work with whatever you get. When implied volatility is high across the board, which it doesn't happen all to often every year where we get kind of the broad market to have high implied volatility, then you get your pick of the litter.
Then you can choose to diversify whatever you want to do, but when you can't find trades in different areas, you got to go a little bit deeper and try to do it on a one to one basis. Next question is, do you prefer ETFS over stocks?
And the answer to this is generally yes, so given the choice meaning that if I was looking at an ETF, which had implied volatility in the ninetieth rank, and I was looking at a stock, which had implied volatility in the ninetieth rank, I would choose the ETF over the stock, given all else being equal, and the reason is because stocks usually have a little bit additional risk, that they could get bought out, or could announce a bankruptcy, or a merger, whatever the case is, generally you're not going to get that type of huge one day, unsystematic risk movement in a stock.
So all else being equal I would choose the ETF, does that mean I prefer those over stocks? Not necessarily I prefer whatever has the highest implied volatility so if 10 ETFS have implied volatility at the sixtieth rank, and 10 stocks have implied volatility at the ninetieth rank, I'll choose the 10 stocks first, try to make trades in those before I work my way to the ETFS, okay.
So that's always the choice. Next question is should we diversify across different options strategies and timelines? And the answer to this question is without a doubt yes, in fact, if you think about it when you are trading our goal here is to create a consistent reoccurring stream of income.
If you only traded one month and didn't worry about planting seeds or making trades for the next month coming up, then you don't have any foresight, or projection of where you think your incomes are going to be. So I agree with the notion of really focusing in and honing in on the most profitable strategies.
Those are the short premium strategies, straddle, strangles, iron condors, credit spreads, et cetera, but maybe having a good mix of some of the other ones, just a couple to make some small bets, in case implied volatility continues to go higher, or whatever the case is and then also diversify out over time. So this is a look at my portfolio, right now as we're just recording this video.
Just to give you an idea, but you can see now that we've got iron condors, we've got a bunch of straddles, and strangles, because that's generally where we make most of our money, and you can see the iron condor, and the straddle, and strangle, you're making most of our money right now on these two short premium trades or strategies, versus what we are losing on the two other long volatility strategies, which is our calendars, and call debit spreads.
So it's not that we need to not trade these, we can trade these on a very small scale, okay a hundred bucks of potential loss here, maybe before they get closed out. Maybe twenty dollars here for a calendar, but we've got a little bit of diversification, so if implied volatility does go up, some of these strategies are going to win, and they'll help kind of buffer some of the profits, and potential losses that we might have on short premium.
Still, short premium strategies are the bulk of what we are making right now. I mean this is where we're making our money on short premium strategies that we're trading. It's just that we have diversification, now that also means that we've got diversification out over time.
So like just one example of this and a quick example is, we've got an iron condor in USO, this thing expires in 14 days, we've got this IWM trade, this thing expires in 49 days. So it doesn't matter how you set this up, there's no perfect way to do it, but it's just understanding, that you should stagger and stack, some of your trades out over time.
So have trades that work in the front contract month, which is right now April, have some trades that work in the back contract month, which is right now May, you just want to have a little bit of spread, in those trades out over time, which will help you out.
The last question is how do I know if I'm correctly diversified? The answer is there is no correct diversification, there is no way to know that you are 100% correctly, perfectly, whatever you want to call it diversified.
Because there's no ultimate diversification portfolio. What I say is you should always just be checking your portfolio beta wait.
So double check your beta wait relative to whatever index your tracking, because even if you're trading all financials, you can still beta wait for it to an index, and see if you have any risk or exposure, to one side of the other that you might go out and look for trades that help kind of fill that gap.
So again there's no perfect portfolio, there's no way to tell if you're correctly diversified, it's always a moving target, but I mean look you just want to use a little bit of common sense here, trade a lot of different ETFS if possible, in different industries, and sectors, if possible.
The main thing here is that we do want to focus our attention on implied volatility, and short selling options, that's where we get our edge. We need to try then to diversify as much as possible in the underlines that we trade.
So as always I hope you guys enjoy these videos if you have any comments or feedback I'd love to hear it. Ask them in the comments section right below this video.
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