Diversification and Options

Diversification and Options - the great mantra of conventional stock market investing is to diversify your holdings.

Why? Because the purpose of diversification is to protect your overall portfolio in case any single holding suffers a complete meltdown.

If, for example, you've spread your investment dollars evenly across twenty different securities, then the collapse of any single investment would equate to a mere 5% decline of your entire portfolio.

It works in reverse as well.

Assuming the same level of diversification, any individual holding that doubled in value would add just 5% to the value of your overall portfolio. As is frequently the case, the cost of increased security is ratcheting back your potential returns.

Diversification in the traditional sense then takes two extremes off the table - complete ruin and outsized returns.

Don't get me wrong. There is a place for a diversified approach to investing.

Investors with large portfolios or those with no affinity or interest in actively managing their own portfolios have ample choices in the index and mutual fund arenas.

If you're reading this, however, odds are you do possess an above average affinity and interest in active portfolio management. It's also likely that you're not satisfied with average (or below average) returns.

But before you throw diversification entirely out the window and assume out-sized risks in order to target out-sized returns, it's important to recall the purpose of diversification (i.e. protecting your overall portfolio from catastrophic loss).

So the important question isn't whether there are ways to diversify your options portfolio, but rather how effective these techniques are at achieving the underlying benefits of diversifying?

There are essentially four approaches for diversifying options or an options portfolio. Let's explore them individually:

#1 Diversification and Options: Diversify by Position Size -

This is the most common form of diversification practiced by option traders. Various "expert" advice would have you limit your option trading portfolio to a small percentage of your overall investment portfolio. Additionally, the individual trader is also frequently encouraged to allow no individual trade to exceed a small portion - say 5% - of his option trading portfolio.

This seems good advice on paper, but there are drawbacks to using this approach:

It's a lot of work identifying and then tracking and managing the necessary twenty or so different trades that 5% position sizing would require. And if your option trading portfolio is a small subset of your overall portfolio, the potential returns, regardless of your success, simply might not be worth the effort.
Setting up similar option trades with the same expiration date on twenty different securities does not constitute diversification. Suppose you were bullish on the stock market over the next 30 days and you chose 20 different stocks on which to employ bullish option trading strategies, such as bull put spreads (for a credit) or bull call spreads (for a debit). Supposed instead that the overall market declined by 5-10%. What would happen to all those individual stocks you researched so carefully?
It's inefficient unless you have a significant portfolio. Not only would the commissions be ridiculous, but the bid-ask penalty would also take its toll. The more contracts you're able to bundle together in any individual trade, the more efficient your cost basis will be. You'll pay less per contract for debit spreads and receive more per contract for credit spreads. That increased efficiency alone may be the determining factor whether a trade is profitable or not, while setting up a ton of small positions may spread your portfolio too thin for the trades to be cost effective.

#2 Diversification and Options: Diversify by Option Trading Strategy -

This is an interesting approach. Mixing and maxing a variety of different strategies might theoretically offer you some limited protection.

Setting up bullish trades on stocks you like along with bearish strategies on stocks you don't would make it difficult for your entire portfolio to be wiped out by an unforeseen major market move in either direction.

Similarly, you could also set up complementary trades - some that profited from decreasing volatility and some that profited from increasing volatility. After all, the stock market can do just about anything - but it can't do everything all at the same time.

Unfortunately, betting on opposite outcomes, in effect dramatically increases the chances that the market will, at some point, move against one half of your portfolio.

Granted, that's a bit of a simplification. Simultaneously betting on strong stocks and against weak stocks isn't the same as arbitrarily setting up random bullish and bearish trades.

And even if a trade moves against you, you always have the ability to adjust the trade to limit your losses or sometimes even still come out ahead. But still, I'm not convinced that this, in itself, is an extremely effective strategy to protect you from large losses.

It should be noted that certain option trading strategies implicitly contain this form of diversification.

With iron condors, for example, you're betting that a stock won't fall below a certain price on the downside or rise above a certain price on the upside before expiration (iron condors combine a bull put spread with a bear call spread).

If the stock remains flat, falls a little, or rises a little, you'll make your maximum profit. You only begin to lose money if the stock makes a big move in one direction or the other.

And as long as you've collateralized both legs of the trade, the maximum loss can only be 50% of what you've risked since a stock can't expire both above the higher strike price and below the lower strike price.

#3 Diversification and Options: Diversify by Strike Price -

To my way of thinking, this approach shows a little more promise.

If the underlying purpose of diversification is to reduce your overall risk, making adjustments to the strike prices of your trades may have some real appeal.

Regardless of the specific strategy you employ or the specific trade you set up, the various strike prices you choose are essentially a knob you can use to dial your portfolio up or down the risk-reward spectrum.

Assuming less risk and a smaller profit target, although not literally a form of diversification, may nonetheless serve the same purpose.

How you set up a covered call is a great example:

If you buy a $50 stock and write a covered call on it with a $55 strike price, you make a little money from the premium and still allow yourself the ability to profit from a 10% move to the upside ($55 strike price less the $50 purchase price). You also have limited downside protection equivalent to the amount of premium you received.
But if you set up the trade at a lower strike price, say at $50 or even $47.50, you receive much more premium. True, you're excluded from any capital gains participation to the upside, but the stock has to fall a lot more before you begin to lose money.

This may not be diversification in the literal sense, but haven't you essentially achieved the end result of diversification?

#4 Diversification and Options: Diversify by Time -

This is my own personal favorite form of options diversification.

I've written previously about the danger of falling into a monthly income mindset. The principle is the same whether you write credit spreads or purchase debit spreads. If you have all your trades expiring on the same day, you can easily be held hostage by short term factors affecting the entire market.

But market conditions change. What the market is doing now may not be what the market is doing three months or six months or a year from now. If you set up all your trades to expire within thirty days, you'll lose out on this natural form of diversification.

A lot of my own option trades involve writing puts on individual stocks, which theoretically obligate me to purchase a certain stock at a certain strike price should the stock trade or expire below that strike price.

Sometimes I set these trades up to expire one month out, sometimes two months out, and sometimes more - I'm even open to choosing dates a year or more away.

If the stock does fall, and if I'm not as prepared to own it as I originally thought, I can always roll out the position, buying back the put and writing a new one farther out in time.

I obviously won't earn the same level of returns on a percentage basis, but I still generate returns that easily beat money market and CD rates (which is much better than losing money). More importantly, I also give myself the opportunity to ride out down markets.

The end result is that I typically have option trades that expire each month, but those option trades that do expire in any particular month typically represent only one-quarter to one-third of my entire option trading portfolio.

FINAL THOUGHTS

There probably isn't one ideal approach to options diversification. The above is simply a general discussion designed to encourage you to consider your own thoughts on the topic. Your own individual trading style and approach may dictate to a large degree what forms of diversification work best for you.

And, in the end, it probably should be forms rather than form. There's no requirement that restricts you to only one diversification style. Your own portfolio will probably be served best by a customized approach that incorporates elements from more than one diversification method.

For a slightly different approach, check out my profile on Terry Allen, whose variations on calendar spread trading implicitly incorporate some of these diversifications and protections while, at the same time, leave plenty of room for significant profits.

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