The 1 Mistake You Make When It Comes To Diversification And How To Change It

portfolio diversification

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So many people in the investing world talk about diversification like it's the end-all solution to risk.

Spread all your eggs into different little baskets, so you don't get hurt by the big bad market when things go south.

Personally, I think this is a bunch of crap!

Why would you buy a basket of different securities all to have that same basket of securities fall or rise with the market?

This one mistake is so narrow-minded I had to take the time to break it down for you here. As an options trader, you do have the choice to change how you diversify.

The Answer: Strategy Diversification

When it comes to diversification in the world of options trading, I prefer to diversify by strategy and direction.

Trading both options strategies that are one directional like call spreads or put spreads and options strategies that neutral in direction and time gives you much more of an advantage than simply diversifying the underlying stocks.

I've talked about this before when talking about time diversification - spreading out your contracts via different months. But you also need to diversify among strategies.

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Don't Be A 1 Trick Pony

A one trick pony in this business will not get you far. The market doesn't care what you think. And the market will not always go in the same direction or have the same set up each month for that one strategy you want to trade.

Now this doesn't mean you need to learn every option strategy under the sun but you should have a variety of option strategies that help you in different market settings.

When the market presents an opportunity, you can pick that one strategy that works best for that situation.

Why Does This Work Better?

Since we know that markets don't go straight up and straight down, its best to play strategies that have both upside and downside potential at the same time. This allows you to pick then and choose the points at which you take profits.

For example, if you traded a call spread that took advantage of an upside move in the market, you could also trade a put spread at the same time to take advantage of downside move in the market.

If both of these strategies are put on for the next 45 to 60 days then at some point you're likely to have an opportunity to take both trades off at profits. You are not a one-trick pony anymore. Now you're starting to trade and think like a professional.

This also goes for volatility trades as well!

Mix up your portfolio with strategies intended to profit from a decline or rise in volatility. Volatility can expand or contract quickly and you won't have time later to position yourself so do it now and wait for an opportunity to exit.

Time For "Super-Advanced" Diversification

Now you understand that option strategy diversification is a huge part of what you do, let's take it one step further.

We know that general diversification is fine and works quite well, so what you would want to do as an option trader is diversify not only among different stocks, indexes, securities and sectors but also strategy and time.

If you can work towards this goal, you'd be diversifying on all the possible levels you can. The key being that you are the position to take profits during any market move. Now the challenge is patience.

What Say You?

Do you already do this? Add your comments below and let me know what you think about strategy diversification and if you think it's a good idea or full of hot air? You won't hurt my feelings if you disagree I promise.

Image Credit from Behavior Gap

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.