How diversified is your options portfolio? For many traders, this may seem to be an odd question. But it just may be the most important thing you ask yourself as a trader. You diversify your IRA or your 401k. Why not your options portfolio?
I had a conversation with one of my mentoring students about this recently. When this student came to me, he knew one strategy and one strategy only. To be fair, he was great at this one strategy and enjoyed a lot of success with it. That is, until market conditions changed. In hindsight, he realized that he was over exposed in one area, and when the market went against him, he got clobbered.
The problem, of course, is that you don’t know when market conditions will change. So what do you do? Diversify.
It is (arguably) easier to diversify with an options portfolio than it is with stocks. With options, there are ultimately only four exposures. A trader can be:
- Long directionally
- Short directionally
- Long volatility
- Short volatility
The first two (the directional exposures) are mutually exclusive as are the second two (the volatility exposures). That is to say, in each of the four exposures, one cannot be both long and short at the same time. But beyond that, there are lots of permutations of how a position can be constructed in terms of exposure. (See my recent story on options expiration).
For example, a trader can be long directionally and long volatility, or he can be long directionally and short (or even neutral) volatility. One of the first lessons in investing people learn is “don’t keep all your eggs in one basket.” That rule applies here too.
Fixing Your Options Portfolio
So how do you fix an over-weighted options portfolio with a diverse basket of different types of option strategies? To be sure, I’m not talking about having option positions on different stocks. I’m talking about having different strategies.
For example, an out-of-the-money debit call spread in one stock and an out-of-the-money credit call spread in another stock. The debit call spread offers a long directional stance and long volatility. The credit call spread offers short directional exposure with a short volatility position.
Ideally this trader will win on both positions because he is right on the volatility and direction of the stock. However, he may win on one and lose on the other (and, of course, could lose on both). This is a hedge of systemic risk. This diversification allows the trader to take a position in individual stocks, maybe lots of them, and hedge off systemic risk in terms of both direction and volatility ultimately producing a lower risk options portfolio.