Balancing your portfolio

[Kim 7,497]

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.

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[Rogers 263]

I keep a portfolio of IC, RIC, Calendars and Butterflies. Towards to close of the market yesterday I found my portfolio leaning negative into the jobs report. To quickly bring myself more delta neutral without having time to research specific trades I just purchased some slightly ITM puts. The market tanked so I would have been much better off leaving my portfolio alone but I slept a lot better last night.

[Victor 5]

Hello Kim,

In your article, My Investment Strategy for 2012, you discuss a hypothetical portfolio, which has the following allocation:

20% in RUT IC

20% in SPY IC/Butterfly

40% in Earnings trades

20% in Cash

With this allocation having 5 earnings trades at one time will have an allocation of 8% of the entire portfolio per trade.

Since a typical RUT IC/ SPY IC usually spans 2-3 weeks of earnings trades, would you recommend being slightly overweight in those trades in order to ensure a better hedge for earnings trades if the market doesn't move?

By "slightly overweight", I mean, for example, allocating more to the RUT and SPY ICs than to each individual earnings trade. If so, what would be the general rule on the ratio of allocation? In your article, for example, the ratio is 2.5 for each non-earnings trade. There are two of those trades and together they have as much allocation as all of the earnings trades combined.

Thanks in advance for your response.

[Kim 7,497]

The allocation should be based on your risk tolerance - how much are you ready to risk per trade? In case of a large move, ICs can be brutal, so 20% is okay most of the time, but in times of high volatility, it might be too high. I tend to keep more than 20% in cash, so my allocation can look something like this:

12-15% for RUT IC;

8-10% for SPY weekly calendar;

10% per earnings trade, with 3-4 trades open at any given time.

I look at earnings trades as "hedge" to the ICs and calendars and not the opposite, since potentially, ICs and calendars can lose much more than the earnings trades.

[Victor 5]

Thank you for the explanation. I was thinking along the same lines about the percent allocation.

It is enlightening to realize that the hedge is viewed differently by you, because what I have been noticing with my portfolio over the past 3-4 months is that in this environment of relatively low volatility, my earnings trades are mostly breaking even if considered separately from the ICs and Calendars. Most of the return comes from the ICs. Of course, that is considering the fact that I am still learning and therefore getting a somewhat lower performance on my earnings trades.

One more question. What would you consider to be a level of volatility, at which the performance of earnings trades will be substantially better than that of ICs and calendars? Is there such level at all? (I understand that it may depend, since ICs established at higher volatility levels will still be profitable if the volatility comes down from those levels, but still remains high compared to , say, today's) What I am thinking is that if that level existed, would it be possible to adjust the allocation in such a way that would improve the performance of the overall portfolio?

[Kim 7,497]

Your observation is correct. Looking at the last 3 months for example:

April was flat to slightly down for the earnings plays;

May was an excellent month when VIX spiked from 16-17 to 24-25.

June was slightly up for the earnings plays when VIX was trending down, and RUT IC was the best performer for the SO portoflio.

July is flat so far, but SPY calendar is the biggest winner.

I would say that with VIX above 20 and rising, the earnings plays will perform very well.

[Victor 5]

Thanks again. After posting I have realized that it would be quite hard to perform portfolio rebalancing in order to maintain optimal exposure, especially with RUT ICs and Calendars that are supposed to be kept for longer periods of time. It might be one of the problems with my idea.

It's been relatively quiet this month in terms of volatility. I think that it will change by the end of this year. Until then, I'll try to "...not loose too much in between.".

[Rogers 263]

Your observation is correct. Looking at the last 3 months for example:

April was flat to slightly down for the earnings plays;

May was an excellent month when VIX spiked from 16-17 to 24-25.

June was slightly up for the earnings plays when VIX was trending down, and RUT IC was the best performer for the SO portoflio.

July is flat so far, but SPY calendar is the biggest winner.

I would say that with VIX above 20 and rising, the earnings plays will perform very well.

Isn't the VIX around 16-17 right now? Good scenario for starting calendars.

[Kim 7,497]

Yes, I will be rolling the August SPY calendar to September.

[Victor 5]

Kim,

I just wanted to verify something. When we talk about a 15-20% allocation to RUT IC, do we calculate it based on the margin requirements? I.e. if the delta between short and long strikes is 10 and I trade 10 IC contracts at a price of $4.70, then my allocation is = 10*10*100 = $10,000. Which is 10% of a 100k portfolio. Is this correct?

Thanks.

[Kim 7,497]

Correct. This is if you want to be conservative since the 'real" capital requirement is the 1,000 less the credit. So if we get 4.50 credit, the real power reduction will be only $550. With likely adjustment(s), it will be increased to $600-800, but most probably not the full $1,000.

[Kim 7,497]

I think Im going to take each rut IC and take the dollar amount divided by 800 to arrive at the quantity to open.

You can do that as long as you still have some cash balance. Theoretically, if things go really wrong, you still might need the whole $1,000 of the margin.