Lessons from the Pros


Importance of Diversification

This article will address the importance of diversification among instruments when trading options. Although there can be various types of diversification, including using different option strategies, the  purpose here is to discuss diversification among underlying products.

I found the following e-mail in my mailbox from an Online Trading Academy newsletter subscriber:

“Hi Josip,

I just started dabbling with options and don’t know where/how diversification fits in with options. After all, I could just lose what I paid for the options, right?”

This e-mail indicates that the student trades only long options, either a long call (+c) or a long put (+p). In such a case his assertion is accurate. However, there is a need for deeper understanding of the market and the products that are being traded if one seriously wants to trade for a living. One of the easiest ways to start building a base of knowledge is to start with the simplest and most fundamental principles: How does the stock market operate? Although I do not intend to spend the rest of this options article on an in-depth explanation, a short one will be provided.

After the discovery of the New World, European countries would set up new colonies with the goal of extracting valuable goods and bringing them back home in order to earn profit. However, bad weather, poor navigation, or even pirates could pose a threat to these enterprises. To offset these possible setbacks the ship-owners would find a number of investors and sell them part ownership (stock) of these enterprises. The new stock owners who helped to finance the voyage’s costs would, when the ships returned, share the profit according to the size of their share holdings. To help increase the chances of success some investors would invest in multiple enterprises, several ships at the same time. In such cases their risk was spread, hoping that at least one ship would safely return providing a pay back greater than their initial investment. The Dutch East India Company took this simple concept to another level by allowing the investors to invest in the entire fleet, minimizing the risk through diversification and it is from there that the whole stock market gradually evolved. The New Amsterdam Exchange is the humble origin of the NYSE.

Similar to the 16th century Dutch investors, I have “diversification” on three of my option trades. Although diversification has multiple levels, I am still using the archaic & most primitive example in which three uniformly built ships (Iron Condors) are on the same voyage (the same duration). The figure below shows the XEO in a symmetrical triangle going into the July 4th week. The assumption was made that NOT much price movement would take place during the low volume week and that most likely the weekly bar of that week would still be contained within the triangle, and within the two horizontal lines.

Figure 1: the XEO

The technical situation on the SPX & RUT was very much the same; there were symmetrical triangles on both. Hence, basically the very same Iron Condor trades were placed on all three of them.

Figure 2: the SPX & RUT

The logic behind this is that there would have to be some major “storm” or unusual event that could make all three of these ships sink on the same expedition. Yet before discussing the adventure of the voyage let us address the potential profit that was about to be collected if everything worked out smoothly. The table below, Figure 3, shows the premium that was taken in for each of the three traded vehicles.

Tickers XEO RUT SPX Total Max P
Max Profit 1.45 1.36 1.40 4.21

Figure 3

The storm, or unexpected event, took place one day into the voyage. The positive news from Europe caused all three underlyings to rally. Yet just like sailing ships that have a strong wind in their sails they could not all sail at the same speed, some are faster (more volatile) than others, so was the case with these three Iron Condors. All three ships were taking in water during the storm, but some at a more alarming level. The RUT was the most problematic one; however, let us go through them each one by one.

The first listed Iron Condor on the XEO was described in a previous article. The rally caused the XEO to take water in; with the 620 sold call being threatened and a Butterfly was placed on it.

The second one, the RUT, was in a much worse shape. Due to the volatile nature of the RUT, a different type of repair (than the Butterfly) was applied to it. Rather than abandoning the ship at max loss an additional ship was sent on a rescue mission (knowing that both could be lost). Explicitly, an additional Iron Condor was placed on the RUT outside of the existing strike prices. Hence in the case of RUT, the original IC failed to stay within its ranges, but the latter one did stay. The combined result was not a profit yet reduced the loss by the credit received from the second RUT IC.

The third one, the SPX, could be looked at as the flagship. Its sold strike prices were so far out of reach that the flagship was never seriously threatened at all. Below is the outcome of the expedition.

Tickers XEO RUT SPX Overall Outcome
Outcome Winner Partial Loss Winner 2/3 winners (66.6%)

Figure 4

Back in the 1980s there was a song: “Two Out of Three Ain’t Bad” by Meatloaf, and that is exactly the outcome of these three ICs.  As the song points out, 66.6% winning is alright.

In conclusion, rather than having all of our eggs in one basket, we are better off if we spread them out. When trading options, even if we apply the same strategy (in our case Iron Condors) at the same time, there is a lower probability that all of them are going to fail. So learn to think in probabilities and keep in mind that just as the ships of the Dutch East India Company were in a storm on the way to their destination, these three trades were in a storm as well. However, the trades (ships) did not sink. The one that was wrecked (the original RUT IC) was salvaged for what was possible, yet the overall expedition (outcome) was profitable. Keep in mind that disproportionate diversification by size could hurt, so be consistent size-wise.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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