Diversified Trading Stock Options but Still Suffering Concentration Risk

Applying a more complete definition of diversification can help retail option traders diversify their portfolio profitably, beyond equities.

A buddy started online options trading from home, in the last 6 months. He was trading a mix of Verticals, Calendars and Iron Condors using highly liquid Indexes but was failing to get consistent profits. Naturally, I asked, “Which Indexes?”

He answered, “DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP. I’ve incorporated broad-based Indexing across large, mid and small-cap stocks to remove single stock exposure. Having learnt how to trade options with Verticals, Calendars and Iron Condors, I’m spreading across these various Indexes. I’m being careful with money management, 2%-5% per trade, I’ve diversified risk, yes?”

No. He has partially diversified a portion within his portfolio; but, is still suffering concentration risk. All he has really done is allocate capital across multiple products, using various option spread types; yet, all his trading capital is stuck in equities.

In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes. Bear in mind the MNX and the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index. Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP - both the SPY and the XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled. Duplication is not diversification. Even if you allocated capital to the smaller versions of the Dow: DJX, the European style cash settled version of the DIA which is the American style stock settled version. Moreover, if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and away from large-caps, you just sunk more of your trading capital into equities. Again, you cannot achieve diversification by adding more capital in the same asset class. That is concentration risk in stocks. Do not confuse asset category (market capitalization) with asset class.

Why bother diversifying across Asset Classes? To answer this question, I’ll use an example of a well known traded stock: Apple (AAPL). You won’t need to understand Fundamental Analysis to follow the reasoning.

Summarizing a financial extract from its Annual Report, Apple has almost ~30% of its Net Sales distributed across: UK, France, Germany, Spain & Ireland and Japan. Apple’s customers in Europe are paying in EUR/GBP and customers in Japan will be paying in JPY. Even though you are trading Apple directly as a US parented firm listed in the US and the currency of the parent is USD denominated, the company has currency exposure to the EUR/GBP and JPY arising from operating sales entities in those jurisdictions. So, you are already exposed to currency and geographic risks by choosing Apple as a product to trade, even though you are constructing an option trade on the stock.

So, it makes sense, rather than have these exposures wrapped inside the stock, where you are subordinating non-equity risks to the stock, to deliberately surface the risks in Geography, Commodities and Currencies. Then, isolate these elements and trade them directly using optionable Geographic ETFs, Commodity ETFs and Currency ETFs.

Is there an example of a consistently profitable and diversified portfolio to see the merits of trading options beyond equities? Yes. See Trading Profit | Consistent Results to view how to trade options using a multi-asset class set up. Notice how the profits step up gradually, from the mid hundreds to the higher hundreds; then, from the higher hundreds into the thousands. While, the losses are contained within the mid to lower hundreds. Diversification to trade options in non-stock asset classes using Geographic ETFs, Commodity ETFs and Currency ETFs, deliberately dilutes the concentration risk in the portfolio’s P/L.

If you are puzzled, yet intrigued, you may well ask, “I don’t need to Beta-weight the Deltas of my option positions; then, hedge using Futures? Do I need to adjust my existing positions by embedding single options; or, morph the original spread into a hybrid option strategy?”

No, is the answer to both questions. Just as it would not make sense within stocks to say Beta-weight a company like GE to the SMH (Semiconductors Holdrs), there is even less sense to Beta-weight a broad-based Index like the SPY to an Emerging Market ETF, Commodity ETF or Currency ETF. Diversification is designed to break the commonality in correlation between the asset price movements of products, in the retail trader’s portfolio structured for online options trading. Adjustments fail to provide the consistency in laddering up the profits as seen in the portfolio, because an adjusted trade often fails to restore, let alone improve the original profile of the trade’s volatility and probability that was bought or sold.

How is this possible? Volatility can be added to/reduced from the portfolio, as not all Asset Classes or Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or, ALL at the same rate. It is the volatility level across various asset classes that is targeted for diversification.

To conclude, here’s the point to reflect on. While diversification alone does not guarantee a profitable portfolio, do you think you are diversified trading stock options but still suffering concentration risk? Think deeper.