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Kim

Balancing your portfolio

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As a non-directional trader, I'm trying not to be dependent on the market direction. My goal is to make money in any market. To achieve that goal, I need to constantly balance my portfolio in terms of direction and volatility.

 

The first goal is being as delta neutral as possible. That means starting most trades with balanced deltas. What does it mean? If the stock is trading at $50, and I buy a 50 straddle, I'm delta neutral. If I buy a 55 straddle, I'm delta negative. The puts which are ITM have higher delta than the calls which are OTM. So if the stock goes down, the delta of the puts starts increasing faster than delta of the calls decreasing, overall delta becomes even more negative and the trade makes money. However, if the stock goes up, the trade becomes more delta neutral, the puts are losing more than the calls are gaining, and the trade is likely to lose money.

 

What happens if I started delta neutral (with 50 straddle in our example) and the stock went up to 55? It depends if the trade became profitable by that time. If the answer is positive, we can close the 50 straddle and roll to 55 straddle. But what if the profit is still insufficient? In this case, we can let the trade run hoping for the stock continue rising, but we also risk a reversal. One way to hedge yourself, at least partially, is opening the next trade slightly delta negative. This will balance the total delta exposure of the portfolio.

 

For example, after opening the RUT Iron Condor with RUT at 785, the trade became delta negative after the recent run to 825. So I might choose opening my next trades with slightly positive delta to balance my total delta.

 

To be truly non-directional, it is not enough to balance the deltas. We also need to balance our theta and vega exposure. That means that we will have to have a mixture of theta positive trades, like Iron Condors and calendars, and theta negative plays, like our earnings plays.

 

To balance the vega, we need a mixture of vega positive and vega negative plays. ICs are vega negative - they benefit from decrease in IV. The aim is to open an IC on a down day when IV spikes. Calendars tend to be vega positive as well. The reason is that longer dated options are supposed to benefit more from IV increase than shorter dated options. Our earnings plays are vega positive. They will be the most profitable when IV jumps. SO having a mix of strategies will help us to be ready to all scenarios in terms of overall market volatility.

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NIce article Kim.

A major question though. When you say:

The reason is that longer dated options are supposed to benefit more from IV increase than shorter dated options.

If this is the case then why in our earnings plays would we purchase weeklies?

Also,

The first goal is being as delta neutral as possible. That means starting most trades with balanced deltas. What does it mean? If the stock is trading at $50, and I buy a 50 straddle, I'm delta neutral. If I buy a 55 straddle, I'm delta negative. The puts which are ITM have higher delta than the calls which are OTM. So if the stock goes down, the delta of the puts starts increasing faster than delta of the calls decreasing, overall delta becomes even more negative and the trade makes money. However, if the stock goes up, the trade becomes more delta neutral, the puts are losing more than the calls are gaining, and the trade is likely to lose money.

You would ratio one of the sides of the straddle (not sure what the technical options term for it is though) and make it delta neutral that way. OR something I am experimenting with is if I have the 50 straddle and the option goes to 55 then I could add an order of puts to make it delta neutral. It does increase my investment, but I just start a little smaller to begin with.

Thanks again for this article.

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Kim,

A technical forum question. I am following the "Intermediate forum". You now posted this article. If I don't choose to follow this article will I still get the replies to it e-mailed to me? I am following the parent forum called "Intermediate forum", but I'm not sure I get anything other than the first post that way.

Thanks!

Richard

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Kim, u say "One way to hedge yourself, at least partially, is opening the next trade slightly delta negative", with this do u mean the next trade on any stock or the next trade on the same underlying stock?

How can u have a neutral delta of a portfolio when each delta is very stock specific and the IV of each stock or option is specific to that equity. The volatility of say IBM is not related nor similar to that of say HOG nor are the deltas of the two or any other Greek related!!! So a when ur 50 straddle becomes more positive how can a negative delta on another stock balance ur portfolio? The 55 can reverse and the new trade can also lose!!! U can lose or win on both trades as they move separately in the same direction or opposite or even stay put.

I must be getting something wrong here? Am I not?

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Your writings above are very informative. May i ask u to kindly put similar short explanations with each trade u open and close, so we can learn properly and understand ur thinking and how things should be done. It may be boring to others who know what is going on but it will be tremendously helpful for the likes of me :-)

As always, thanks a million for the kind help.

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Kim, u say "One way to hedge yourself, at least partially, is opening the next trade slightly delta negative", with this do u mean the next trade on any stock or the next trade on the same underlying stock?

How can u have a neutral delta of a portfolio when each delta is very stock specific and the IV of each stock or option is specific to that equity. The volatility of say IBM is not related nor similar to that of say HOG nor are the deltas of the two or any other Greek related!!! So a when ur 50 straddle becomes more positive how can a negative delta on another stock balance ur portfolio? The 55 can reverse and the new trade can also lose!!! U can lose or win on both trades as they move separately in the same direction or opposite or even stay put.

I must be getting something wrong here? Am I not?

you are right, a long HOG (delta or any other greek) doesn't directly hedge a short in say IBM and you can still lose on both trades. However the idea is to hedge yourself against a general move in the market (up or down). If the S&P goes up, a specific stock that you have can obviously still go down but the odds are its are going to rise with the overall market. So if you are short delta on one stock the best delta hedge would be to add delta to that specific stock position (via options or shares) second best hedge if you don't want to do that is to add delta (long or short - whatever brings you overall portfolio delta closer to zero) in another stock to your portfolio.

Same idea for gamma/theta - if the market doesn't move much or earnings trades aren't performing as well (as we hope for a big move) but at the same time this is the environment where IC and calendars make money (you don't wont the markets to move for these strategies) so these strategies PARTIALLY hedge each other.

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NIce article Kim.

A major question though. When you say:

If this is the case then why in our earnings plays would we purchase weeklies?

Also,

You would ratio one of the sides of the straddle (not sure what the technical options term for it is though) and make it delta neutral that way. OR something I am experimenting with is if I have the 50 straddle and the option goes to 55 then I could add an order of puts to make it delta neutral. It does increase my investment, but I just start a little smaller to begin with.

Thanks again for this article.

Those IV changes are caused by different reasons. One is caused by earnings, and short term options are getting more bids because they are cheaper and have higher gamma. For general IV increase, the loner term options should increase more in value, although it is not always the case. I will write more about it, probably in the Calendars post.

For delta hedge, you can also roll the 50 calls to 60 calls, this will actually reduce the investment.

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Kim,

A technical forum question. I am following the "Intermediate forum". You now posted this article. If I don't choose to follow this article will I still get the replies to it e-mailed to me? I am following the parent forum called "Intermediate forum", but I'm not sure I get anything other than the first post that way.

Thanks!

Richard

You will get emails from specific topic in 3 cases:

1. If you started the topic.

2. If you posted a reply.

3. If you started following it.

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Kim, u say "One way to hedge yourself, at least partially, is opening the next trade slightly delta negative", with this do u mean the next trade on any stock or the next trade on the same underlying stock?

How can u have a neutral delta of a portfolio when each delta is very stock specific and the IV of each stock or option is specific to that equity. The volatility of say IBM is not related nor similar to that of say HOG nor are the deltas of the two or any other Greek related!!! So a when ur 50 straddle becomes more positive how can a negative delta on another stock balance ur portfolio? The 55 can reverse and the new trade can also lose!!! U can lose or win on both trades as they move separately in the same direction or opposite or even stay put.

I must be getting something wrong here? Am I not?

You are correct in general. However, the correlation between different stocks is pretty high recently, and many stocks move in tandem. This is especially true when you hedge the index trades like the RUT IC.

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Hi Kim,

One question for you.

Assume I have only 2 trades in my portfolio. One is 50 KEY calls with 1483 deltas and the other one is 3 WMT puts with -132 deltas. In IB portfolio manager, it just sum these two numbers together so I have ~1351 deltas in total. In order to be delta neutral, I can add around 31 WMT puts. However, since the KEY stock is so cheap(around $7.4), it's very difficult to move one dollar in the short timeframe. Relatively speaking, WMT is at $67.8 and can be easily up or down for 1 dollar. In this case, though it looks like delta neutral, actually my profit or loss will largely affected by WMT trade, right? Do I overlook or misunderstand anything? Thanks so much.

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You are absolutely right. This is not apples to apples comparison. Delta neutral applies only to the same stock, comparing deltas on stocks with different prices is meaningless.

For example, if you have one ATM call at $10 stock and one ATM put on $100 stock, your total delta will be 0. However, assuming that both stocks have 100% correlation to S&P 500, your portfolio is actually very bearish.

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You are absolutely right. This is not apples to apples comparison. Delta neutral applies only to the same stock, comparing deltas on stocks with different prices is meaningless.

For example, if you have one ATM call at $10 stock and one ATM put on $100 stock, your total delta will be 0. However, assuming that both stocks have 100% correlation to S&P 500, your portfolio is actually very bearish.

Thanks for your quick response. So I guess this is why you said adding some opposite delta into your current portfolio is "partially hedge".

Umm...just a dumb idea...Do you think it make sense to standardize the delta with respect to its stock price? Like we can divide the delta by its stock price, and then based on the "new delta" to make our portfolio to be neutral. Thanks! :)

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As a relatively new member, have been reading the above posts with great interest and they have answered most of my questions about delta neutral positions. One question, however. How close to 0 do you have to be for the position to be considered to be neutral. currently I am at -169. Would you consider that close enough? Thanks in advance

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if you use the IB risk Navigator there is a column 'delta dollars' which lets you compare deltas in dollar amounts so you can compare a 1$ stock with a 100$ stock

One thing to keep in mind about the IB Risk Navigator. Its calculations are often worthless. It uses for its price values the last trade value, not the bid or not the ask or not the midpoint. Why is this a problem? If the option and/or stock has low liquidity and your position has multiple legs, each leg may have traded at far different times--perhaps even different days! This makes IB Risk Navigator's resulting calculated values incorrect (actually, worthless).

I've mentioned this to IB Support, and the guy I spoke with tried to convince me that this way of doing it (using the last value instead of current market value) is a better way since the tool is using real prices. When I explained again the possible time disparity (thinking he must have not heard me correctly), he didn't seem to know what I meant. So much for IB Support.

Anyway, be careful when using IB Risk Navigator.

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IB support is pretty much useless. This is the biggest drawdown of IB. Many times they simply don't know what they are talking about.

As for delta neutral, it is relative for the size of the portfolio. -169 might be too much for smaller portfolio - it's the same as to ask if $1000 gain is a good gain? The answer is - very good on 10k portfolio, not so good on 1M portfolio. So there is no one good answer here, it should be close to zero in percentage terms.

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One thing to keep in mind about the IB Risk Navigator. Its calculations are often worthless. It uses for its price values the last trade value, not the bid or not the ask or not the midpoint. Why is this a problem? If the option and/or stock has low liquidity and your position has multiple legs, each leg may have traded at far different times--perhaps even different days! This makes IB Risk Navigator's resulting calculated values incorrect (actually, worthless).

I've mentioned this to IB Support, and the guy I spoke with tried to convince me that this way of doing it (using the last value instead of current market value) is a better way since the tool is using real prices. When I explained again the possible time disparity (thinking he must have not heard me correctly), he didn't seem to know what I meant. So much for IB Support.

Anyway, be careful when using IB Risk Navigator.

that means you'll have jumps in the P/L column, delta shouldn't be as much affected and close enough for roughly balancing your portfolio. But yes you are right: the Navigator could be better and so could be their customer support :)

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Your writings above are very informative. May i ask u to kindly put similar short explanations with each trade u open and close, so we can learn properly and understand ur thinking and how things should be done. It may be boring to others who know what is going on but it will be tremendously helpful for the likes of me :-)

As always, thanks a million for the kind help.

If it would not be too much hassle, I would also love to see something like this. I think this information would be very useful for the new traders trying to learn how to implement these trading strategies, such as ammarmalhas and myself. I'm new to these trading strategies and seeing your thought process and reasoning behind the trades would greatly help me understand the logic and improve my knowledge base.

Thank you.

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That was misphrased a little, sorry for the misunderstanding. I'm not looking for additional information in each trade post, rather just an explanation I could use to better understand the use of the greeks. The part I'm struggling with is the process of how you use each of the greeks to rationalize the actual trade. I understand that it is important to be as close to delta neutral as possible. I also understand how to calculate the theta/vega ratio to see the IV increase required to offset the theta, but my major stumbling block was trying to figure out how you predict the increased volatility of the underlying stock? Just by looking at previous IV through optionistics and hoping it follows trend?

Thanks

----------------------------------------------------------------------

- Edit : Question was answered in my other post related to placing earnings plays ( http://steadyoptions...earnings-plays/ )

Thanks Kim

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That was misphrased a little, sorry for the misunderstanding. I'm not looking for additional information in each trade post, rather just an explanation I could use to better understand the use of the greeks. The part I'm struggling with is the process of how you use each of the greeks to rationalize the actual trade. I understand that it is important to be as close to delta neutral as possible. I also understand how to calculate the theta/vega ratio to see the IV increase required to offset the theta, but my major stumbling block was trying to figure out how you predict the increased volatility of the underlying stock? Just by looking at previous IV through optionistics and hoping it follows trend?

Thanks

AND my past experience with the stock.

Those trades are about probabilities. If something worked in the previous 3-4 cycles, it just gives you a better chance that it will work this time too. The trick is to get it at the best possible timing and the best possible price.

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Kim,

I have a newbie question : Why create a delta neutral portfolio in the first place?

Somehow it seems to me that neutral = no change/no profit.

At some point something must generate a profit for the whole system to work.

Obviously it does (my account is significantly up since joining your club.)

But I don't really have a deep understanding of why. (Unlike my understanding of directional trades.)

Please could you expound a little on the reasons/philosophy, pro and con of delta neutral.

Or point me at a good info source.

Thanks in advance.

Best

Dave

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I'm revisiting this old topic to show what I mean by balancing the portfolio using our current portfolio as an example.

 

We currently have 6 positions:

 

KR and COST straddles - vega positive, gamma positive, theta negative

JOY and AZO earnings calendars - vega positive, gamma negative, theta positive

RUT and AAPL calendars - vega positive, gamma negative, theta positive

 
I believe this is a good mix of different strategies providing an excellent balance. RUT will continue gaining value quickly if the market stays in the current range since this is a weekly trade. AAPL will provide a slow and steady increase in value if the stock stays range bounded. The earnings straddles are cheap and provide nice insurance in case the markets make a sudden and quick move, but can provide gains of their own in case of modest IV increase or stock movement. And pre-earnings calendars take advantage of favorable IV skew between the short and the long options.

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Kim would you be able to another analysis of current trades similar to your post above (which was incredibly useful)? For example, if there is a significant event which causes the VIX to spike do we have any current trade to protect against this? Thank you.

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