A Problems with Many Traders: Lack of Diversification

One of the problems with many of the traders that come to me seeking coaching is lack of diversification. I’m not talking large caps vs. small caps or techs vs. emerging markets. That sort of diversification is more in the context of investing—not trading. As option traders, we must diversify our option-centric risk. We must manage our delta, gamma, theta and vega risk.

Never has the need for option-centric risk diversification more clear than in a market like we are in currently. The market—for the better part of this year—has been somewhat sideways, while being decidedly volatile. Any trader who has held all long-delta positions during the up-turns got it handed to them when the market quickly reversed course. Long and wrong. Alas! Likewise did shorts get shaken out when the market shot higher as it did several times this year as well.

The same risks have been a challenge for income traders of late. We’ve seen some recent scenarios where the market turned horribly against income traders. There have been market situations where a trader may have implemented a well set up a (short-vega) income trade, only to see implied volatility rise sharply, confounding their volatility position, making the trade much less attractive and even a short-term loser.

How do traders avoid concentrated option-centric risk? Simple: diversify. Traders must focus on having some long-delta trades long with some short-delta trades. They should be long volatility in some names and short it in others. They should have positive theta in some, and concede negative theta (for the benefit of positive gamma and limited risk) in others.

The overriding principle in options diversification is that traders must consider trades from a portfolio perspective. Essentially, traders should consider their portfolio as one single (though possibly very large) trade—a master spread, if you will. Traders need to use a few different techniques in order to analyze this master spread.

First, they must consider each position within the portfolio as one leg of the master spread. For example, imagine a portfolio consists of a put credit spread in AAPL, a long call in F and an iron condor in MMM. This is to be regarded as one trade—one big spread. The AAPL position is one leg, the F position is one leg and the MMM position is one leg.

Next, traders should study the aggregate greeks of the portfolio as well as a profit and loss diagram of the aggregate portfolio to make decisions about risk, adjustments and adding new legs. Just as one would study the delta, gamma, theta and vega of an individual option trade, likewise would the trader analyze the greeks for the master spread. Most options-friendly brokers make it easy to view portfolio greeks and a profit and loss diagram of the aggregate portfolio. Portfolio greeks help traders understand their overall risk in terms of market direction, total time decay risk and total volatility risk. A profit and loss diagram of the aggregate portfolio helps traders in understanding their “up-and-down” risk of the portfolio; that is, the risk endured if the broad market makes a big move in either direction.

When it comes to portfolio deltas, traders need to get a little more specific. The deltas of each individual leg (individual position) must be normalized. Case and point, being long 100 deltas in GOOG is not the same as being long 100 deltas in MMM. Deltas must be “beta weighted”. Beta is a measurement of the correlation of an individual stock to the market (generally it is its correlation specifically to the S&P 500). Beta weighting deltas effectively translates all deltas into SPX deltas. In other words, if a trader is long 300 deltas in GOOG, it is equivalent to being long X deltas in SPX. This enables traders to compare deltas on different positions on an apples-to-apples basis.

The question arises: What should the portfolio greeks be? The premise of this article is to have offsetting greeks among the legs of the master (portfolio) spread. But the net portfolio greeks needn’t be zero. Traders may have a directional bias in the market or on market volatility, allowing for a decisive aggregate position in each portfolio greek and each individual position.

To that point, the objective for each individual trade (long or short in delta, theta or vega) is certainly for it to be a winner—and, ideally, that’s how it works out. However, having offsetting greeks within the portfolio helps lessen the individual-equity risk of each, distilling the risk towards pure systematic risk. Then, the trader may adjust the portfolio greeks to also optimize the desired exposure to the market as a whole.

Dan Passarelli