How to Use Pairs Trading with Options to Create Smooth Portfolio Growth

On today's newest podcast I want to turn the conversation a bit and focus on pairs trading with options. And this isn't the traditional pairs trading that you might have heard about before where you short one stock and buy another related stock to profit from any trending differences or divergences in the underlying price. Instead, I want to talk about how you can use some very basic portfolio and stock beta concepts to make smarter, more efficient decisions about which securities you use for options trading. Moreover, I want to give you the knowledge to feel comfortable taking directional trades so long as you know how to create "paired trades" that still give you an overall neutral stance relative to some benchmark index. This show is a little more advanced but I think you'll find it helpful.

Key Points from Today's Show:

• Pairs trading with options to create smoother portfolio growth, smoother returns, and reduce the volatility in your account.
• Portfolio beta weighting has to be the foundation of what you do with your trading.
• If you understand where your portfolio sits at any point in time, then it is very easy to go out and find new positions.
• When it comes to trading, you should know what you're looking for so that you are more targeted and focused.
• Be cognizant of what you are actually adding to your portfolio.
  

Example: If your portfolio is too bearish, then you need to focus on finding more complimentary bullish positions.

Portfolio Beta Weighting

Adding Bullish Positions:

• If you need more bullish positions, search for trades/ETFs/stocks that are highly correlated with the market.
• Can use beta weighting to determine how correlated the security is with the market.
• For bullish positions, focus on securities with a beta of 1 or more.
• A stock with a beta of 1, tracks the S&P 500. A stock with a beta of -1, will track the opposite of S&P 500.

Example 1: SMH has a beta of 1.16. If the market moves up 1 point, the SMH would move up 1 point plus. So it would move up even more than the market. If you need a bullish position, you might go after something like SMH because SMH has a positive correlation with the market and is going to move a little bit ahead of the market if the market's rallying, which helps correct your portfolio much quicker.

Example 2: TLT, a major bond ETF, has a beta of -0.26. A -1 would suggest that TLT moves the total inverse of the market. Since it is only -0.26, if the market moves up 1 point, TLT might move down a quarter of a point. So if you want to get bullish exposure in your overall portfolio, you can't just buy TLT because buying TLT actually gives you exposure to the market going down. If the market goes down, TLT goes up. Might have to sell four times as many positions in TLT to get the same impact as one bullish position in SMH.

*If you are trying to get a bullish position on your portfolio, TLT would require almost four times as many contracts to get the same impact as SMH

Example 3: SLV is a silver ETF. Silver has a beta of 0.06, almost a zero correlation with the market. So adding silver to your portfolio while adding another bullish position really does not help balance out what you have. Not a complimentary trade to your portfolio.

Adding Bearish Positions:

• Buy long TLT because TLT has a negative correlation to the portfolio.
• Even though you are adding a bullish position, because of its correlation to the market you are adding some exposure incase the market goes down.
• If the market goes down, TLT should go up based on it's correlation/beta.

Insight

"With $160 billion under management, if you have 15 uncorrelated return streams you can reduce your risk by as much as 80%.”

• In your portfolio, try to have as many weak or loose correlations to the market as humanly possible.
• Month-to-month correlations change over time.

Pairs Trade

• FXE and SLV are two weak correlations right now that can be traded at the same time.
• Do not have to be cognizant of trading them in any one direction; bullish or bearish.
• Can easily add these to your portfolio and not have any skew happen in your portfolio.
• If you add anything with a strong correlation, you have to add another trade to compensate for its impact.

Example: XOP is an oil and gas ETF with a beta of 1.51. When the market moves higher, XOP should move just as high and then even 50% more, potentially. If the market goes a point higher, XOP should move 1.5 points higher. If you add a long position in SMH, which now you're adding 1.16 additional betas to your portfolio, you could also take a short position in XOP and neutralize that impact by a large margin. Now it's not going to be 1-to-1, but it will give a neutral impact overall on your portfolio.

Conclusion

• In today's world there are very few ETFs that have a perfect positive correlation or perfect negative correlation, or a perfect no-correlation.
• Therefore it is going to be much more of an art form than exact science for your portfolio.
• Overall, you have to be really efficient with how you use your capital and how you correlate and beta weight your portfolio.
• It all gets back down to beta weighting and figuring out what you need in your portfolio, and then finding the most efficient piece to add in.