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Every trader knows that trades can move against a position. With wise analysis and careful selection, the market risks can be reduced. But if all your options are written on stocks in the oil and gas sector, or retail, or Internet companies, a sector-wide downward cycle could hurt all your positions. Options traders, like all traders, will improve their success and reduce market risks by being aware of the need for diversification in terms of market sectors, specific companies, options strategies, and timing of trades with many other things in mind (ex-dividend date and earnings announcements, for example). Diversification is not well understood. To many, simply buying shares of several different companies is adequate. However, if all those companies are subject to the same market and economic forces, are you truly diversified? Of course, you are not. It’s more than just expansion of sectors that defines true diversification. Many dissimilar sectors face the same types of market risks. To diversify, you need to diversify market risks. This means options traders need awareness of cyclical forces for companies, not just for options strategies. For example, if you own shares in four of the major oil companies, all of them are going to rise and fall due to the same changes in the market, commodity price, OPEC decisions, and more. This is not diversification; in fact, it is just the opposite, a concentration of capital in a narrow area. Some options traders, aware of the leverage options provide, tend to ignore this and to fall into the belief that market forces for a company do not affect the valuation of options or the change in option premium. Just as stock investors experience varying levels of market risks, options traders do as well. It is important to be reminded that options are called derivatives because their value is derived from movement in the underlying security. This means there is a direct relationship between historical volatility and option valuation. Many traders ignore historical volatility, favoring implied volatility (IV) of the option. But this tests and predicts option volatility alone and not the underlying volatility. Because IV is based on estimation, it is less reliable for diversifying risk than the more precise measurement of historical volatility. For many devoted options traders, the suggestion that implied volatility should not be considered in assessing risk is a form of heresy. But it is a rational point to make. Here’s the point: If you are not diversified, market risk can have an immediate and negative impact on your options trades, no matter how much prediction from IV is involved. Even if you accurately estimate future IV, a key point to keep in mind is that IV forecasts levels of risk, but not direction of price movement. An option may react to stock prices in a low or high volatility level; but IV measures degrees of change, not whether prices move up or down. To some traders, this comes as a surprise. A popular assumption is that tracking IV allows a trader to predict whether to be bullish or bearish. It does not. Diversification is not the answer, any more than estimating volatility ensures well-timed trades in the right direction. A lack of diversification exposes traders to market risk which might be greater than their risk tolerance finds acceptable; and that is the problem. If you could find “sire thing” in an options trade, you would not have to worry about diversification. It would be possible to put all your money in a single trade and just collect profits. Is this an unlikely scenario? Not at all. For example, many covered call traders believe they are not exposed to risk in any form. These are foolproof trades. The truth contradicts this assumption. If the underlying price falls below your adjusted basis (price of stock minus option premium received), you have a paper loss and you must either wait for the price to recover or look for a recovery strategy. On the upside, maximum profit is limited to the premium you received for selling the call, meaning the lost opportunity of a rapidly advancing underlying price should be kept in mind as well. Covered calls are not foolproof, meaning the need for diversification must be expanded beyond spreading money around among different companies. It also requires diversification of options strategies and risk exposure. The lack of diversification is subtle. For example, owning shares of different companies not in the same industry may be equally non-diversified. Just because a portfolio consists of stock in companies of different market sectors, does not mean the portfolio is diversified. By the same observation, limiting yourself to only one strategy represents an equally serious form of non-diversification. For example, if all you write is a series of covered calls, a marketwide bull trend could lead to exercise of all your positions – and to significant lost opportunity. True diversification takes many forms. If you limit the form of diversification to stocks, make sure the sectors involved are not subject to the same influences. Don't overlook cheaper and often forgotten stocks, either. Your profit potential can be enhanced with quick and easy ideas for these companies. Beyond direct ownership of stocks, you can diversify by: Buying shares of ETFs or index funds and writing options on those positions. Diversifying by degrees of risk, for example combining selection of strong value investments with less speculation in more volatile growth stocks, again opening covered options on this portfolio. Combining stock ownership with option speculation, exposing you to potential capital gains from market activity along with current income. Dividing a portfolio among stocks, bonds, commodities and real estate. (And by the way, you can invest in any or all of these without owning directly, if you seek a specialized ETF with ease of trading and built-in diversification within each ETF). Trading options in place of stocks for maximum leverage and risk reduction, and opening calendar spreads to hedge market risk in existing equity positions. In summary, just be sure that the various baskets contain different kinds of eggs. Most traders and investors know better than to put all their eggs in one basket, but if you are carrying all the baskets at the same time and you trip, don't all the eggs break? Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
This type of rationale can also be applied to the equity markets with the size and value factors. Fama and French wrote about this nearly 30 years ago, with the implications being implemented by Dimensional Fund Advisors (DFA) and others in the financial industry. Many investors don't maximize the diversification benefits that are available in the equity components of their portfolios. Diversification is often thought of primarily as a stock/bond allocation decision, but there is more to it. Market cap weighting means that even a total stock market fund is still nearly identical to the S&P 500. Whether it's large or small stocks, growth or value, domestic or International...bear market correlations do generally (but not always) rise in equities (meaning they all tend to decline at the same time). But there is more to diversification than just the temporary declines associated with bear markets. Let's look at a simple example: 1990-1999: S&P 500 annualized return: 18.21% DFA Equity Balanced Strategy Index: 13.71% 2000-2009: S&P 500 annualized return: -0.96% DFA Equity Balanced Strategy Index: 7.40% 2010-2018: S&P 500 annualized return: 12.75% DFA Equity Balanced Strategy Index: 10.44% 1990-2018: S&P 500 annualized return: 9.93% DFA Equity Balanced Strategy Index: 10.88% The S&P 500 may indeed be a passive index, but only (or heavily) allocating to it for a portfolio is indeed an active decision since it only represents US large cap stocks. It almost certainly should be a part of a well diversified equity portfolio, but so should small cap and International equities. Tilts towards small and value may also offer investors a return premium, or at minimum, diversification benefits. The starting point for an equity investor should be a globally diversified portfolio as a sensible way to earn the equity risk premium. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.
Since June of 1986, they've both carried Sharpe Ratio's of approximately 0.5. Sharpe Ratio measures excess annualized return / annualized volatility. Excess return is the annualized return of the mutual fund minus the risk free return of T-bills. Portfolio 1 = VFINX Portfolio 2 = VUSTX We see that VFINX had a higher return, but also higher volatility. This is what we would expect over a long period of time from relatively efficient markets. And we'd also expect similar Sharpe Ratio's like we see. So what's the benefit of diversification? Well, a risk parity portfolio, where both assets contribute about the same amount of volatility, would mean we need about 40% in VFINX, and 60% VUSTX. Portfolio 1 = 40% VFINX, 60% VUSTX We immediately see the benefits of diversification where the 40/60 portfolio Sharpe Ratio shoots up to 0.73. That's substantially higher than either mutual fund itself, and even higher than Warren Buffett during this same period where BRK/A produced a Sharpe of 0.64. This means the benefits of diversification are making a portfolio more efficient by offering higher returns per unit of risk. Are you thinking right now, "yeah, but the return is still less!". That's true, and it's why I often find investors believe that diversification lowers returns. This ignores the ability to use leverage. Let's assume in the following examples that we can borrow at the risk free T-bill rate. This is unrealistic, but the futures market does provide implied financing rates relatively close to this over time. With the ability to use leverage, either by borrowing funds directly through a source of financing such as a bank or a margin loan from a broker (i.e., Interactive Brokers), or indirectly through derivatives like futures and options contracts, we are no longer constrained to investing a maximum of 100%. This means we can use the benefits of diversification to either A. produce similar returns with less risk or B. produce higher returns with similar risk. A. Similar returns (as 100% VFINX) with less risk by investing 25% more in each fund (50% VFINX, 75% VUSTX). Financed at the T-bill rate. B. Higher returns (than 100% VFINX) with similar risk (defined as "Stdev", or annualized volatility) by investing 100% more in each fund (80% VFINX, 120% VUSTX). Financed at the T-bill rate. These examples are meant to be just that...examples. Leverage creates risks of its own that investors should be aware of, but I personally like the benefits of using moderate amounts of leverage applied to a diversified portfolio to increase expected returns, vs. the more conventional method of simply investing more in stocks. To each his own. I mentioned that we'd compare the results of our leveraged portfolio to that of Warren Buffett's (via BRK/A). So let's take a moment to do just that...interestingly enough, academic research has concluded that a material amount of Buffett's outperformance was due to just that...leverage...1.6X on average. "Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks." Portfolio 1 =BRK/A Portfolio 2 =80% VFINX, 120% VUSTX Our 2x levered portfolio slightly underperformed BRK/A on an absolute return basis, but slightly outperformed on a risk adjusted return basis due to having approximately 30% less volatility. The risk here for retail investors is when the thought crosses their mind "well, if I can lever up to 200%, why not MORE ?" Hopefully I don't have to explain the risks of leverage...just because you can drive a Ferrari 200 mph doesn't mean you should! A rule of thumb is that if you model your portfolio annualized volatility to be more than ~20%, you're probably driving too fast and eventually you're going to crash. For this reason, only highly sophisticated and highly disciplined investors with a strong understanding of modern portfolio theory, statistical probabilities, and quantitative finance should attempt to create portfolios like this on their own. There are many variables to consider, and it's never as obvious as it looks. "You've got to guess at worst cases; no model will tell you that. My rule of thumb is double the worst you have ever seen" - Cliff Asness, AQR "Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there is pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe Ratio of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe Ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need." - Cliff Asness Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse oversees the LC Diversified forum and contributes to the Steady Condors newsletter.
Of course we all know that CNBC's first priority is to increase rating to sell advertising, not to make you money. But this is a separate topic. What is diversification? According to Investopedia, diversification is "A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated." According to Warren Buffet, "Put all your eggs in one basket and then watch that basket very carefully. Diversification is Protection against Ignorance" - which means that you diversify when you are not sufficiently confident to bet on which asset (or asset class) will do well and which will do poorly. According to Mark Cuban, "Portfolio diversification is for idiots. You can't diversify enough to know what you're doing. You've got to do your homework and play your best bets" According to Jason Sweig, "For anyone with a sustainable ability to identify the hottest investment of the moment, diversification is a mistake. But if you really believe you've got that ability, you're not just mistaken. You need to be hauled off in a straitjacket to the Institute for the Treatment of Investment Insanity. But when it comes to investing, there's only one sure bet: that sure bets don't exist." So who is right? Let's say you owned a nice diversified portfolio at the end of 2007. How would it help you? AAPL declined 60% from $200 to $80. CSCO declined 60% from $34 to $14. C declined 98% from $55 to $1. GOOG declined 66% from $750 to $260. GE declined 85% from $42 to $6. F declined 90% from $10 to $1. Of course many of them recovered, but would you know to buy them at the bottom? And some of those stocks are still trading below 2007 levels. But here is the biggest problem. As Bespoke Investment Group correctly point out, "One of the problems with diversification is that during times of turmoil, asset classes tend to become highly correlated, defeating the purpose of the diversification in the first place. This was especially true during the financial crisis in late 2008 when hedge funds and other asset managers were hit with massive redemptions. This caused even a safe haven like gold to fall along with everything else." Diversification works well during bull markers, because securities tend to have low correlation - some of them will zig when others zag. But during bull markets you don't really need to be diversified - most stocks will go up anyway, or you can just buy a broadly diversified ETF lile SPDR S&P 500 Trust ETF (NYSEARCA:SPY). But when a bear market arrives, all stocks start to move in the same direction. Just when diversification is needed the most, most stocks become highly correlated. What is the solution? As we always say, you can't control returns, only manage risk. I really dislike when people make trading sound like if you are really good at it you somehow have control over your returns. The only thing you can do is build a winning strategy (better yet, multiple winning strategies with low correlation) and then manage your risk and position size so that you stay in the game long enough to let your edge work out over the long term. No single strategy is the holy grail. The key to long term success is to build your portfolio based on few different strategies with low correlation. Owning 20-30 different stocks from different industries is not diversification. "By adding short and hedged investments to a portfolio in a systematic way diversification is significantly increased. 2008 is a recent historical example where a global sell-off can cause correlations among asset classes to reach unusually high levels. When virtually every major asset class goes down, a portfolio diversified only by owning different asset classes can still experience large losses that can cause many investors to abandon their long-term plan. Diversifying across strategies helps mitigate this risk. The idea of a diversified portfolio is not to beat a benchmark like the S&P 500. Diversification is about building a portfolio for the maximum potential return with the least risk. Diversification is about creating the most consistent equity curve possible. In Geek Speak, we're talking about maximizing our Sharpe Ratio. To do that, diversification requires unrelated strategies. Unrelated strategies ensure that in the short term there will almost always be something in your portfolio that you love and something that you hate. Creating a robust portfolio is a form of 'alpha' in itself." - Jesse Blom Want to join our winning team? Start Your Free Trial