Not Your Daddy's Diversification: Hedging Risk Like a Trader

Remember the bad old days, when investors just bought a single stock and hoped for the best? Then came the ’80s, when star mutual fund managers sold us on the benefits of “diversification"—particularly the diversification that came from their funds. So then investors bought a couple funds and, once again, hoped for the best.

Diversification for a stock portfolio is a way to reduce “non-systematic” risk. Systematic risk is the danger of the whole market dropping and all stock prices falling along with it. Non-systematic risk is the danger that is unique to a specific stock, such as management skill, products, legal rulings, and so on. The idea is if you have enough different stocks in your portfolio, all those company-specific risks offset each other, and no single risk will dominate your portfolio.

All that's fine. But when you're a floor trader standing in a trading pit that's only trading options on one index or stock or future, diversification across different underlying securities isn't really possible. So, you think about diversification in a different way. Different spreads have different risks—some lose money when the stock goes up; others, when the stock goes down. Some lose money when volatility goes up; others, when volatility goes down. Retail option traders and investors can trade any stock or index they like, but they can still benefit from thinking about how an option trader might diversify. Let's look at a few different approaches.

Hedging Directional Risk

First, let's look at the net risk of your positions. Right now, go ahead and launch your thinkorswim^® from TD Ameritrade trading platform and look at the Position Statement section of the Monitor page. You can see that each symbol's net position greeks are displayed. (You can do this exercise whether or not you have option positions, because even stocks and mutual funds have delta.)

Are the net deltas all positive? That means you want them all to rise—at least a little bit. What happens if the market falls?

If you beta-weight the positions to a common index, is there a particular symbol that has a much bigger delta than the others? That means that your portfolio's risk is concentrated in that one symbol. (See sidebar, “Bet Your Bottom Beta.") It's okay to have a stronger bullish bias on a particular stock, but make sure you understand the risk it presents to your portfolio. If that one stock crashes, it can wipe out all your other gains.

Hedging Time and Vol

If you do have any options in your positions, you'll notice other greeks in addition to deltas—theta and vega in particular. While stock trading is somewhat one-dimensional—stocks only go up and down-option trading has to contend not only with the stock's movement (delta), but also with changes in volatility (vega) and time passing (theta). An option trader can be right in picking the direction of a stock, but be wrong on time and volatility—and lose money. That means that the trader who ignores all the factors that affect options could be blind-sided by any one of them.

Earlier, you looked at delta. Now look at vega—do all your positions have either positive or negative vega? Negative vega means your positions are losing money as implied volatility drops, assuming no change in the stock price or theta. If every position has positive vega, what happens if volatility drops? You should look at theta in the same way as well. Are all your positions negative theta, which means your option positions are losing money as each day passes (assuming no change in the stock price or volatility)?

Just because all the deltas, vegas, and thetas are “pointing” the same way isn't necessarily bad, as long as you understand the risks. If you are very confident in the direction of stock prices or volatility, then perhaps your portfolio is appropriate. But if you're not too confident, and I don't know many traders who are, then you might want to diversify a bit. Different option strategies such as vertical spreads, calendar spreads, and iron condors have different delta, vega, and theta characteristics, so it's a good idea to learn more about them. Diversification with options comes from mixing them so that the portfolio has the delta, vega, and theta risk that you're comfortable with. No single risk should dominate your portfolio.

Be a Nimble Strategist

As a market maker, I didn't diversify with a particular trade in mind. Rather, as orders would come into the pit, I would think of them as either increasing or decreasing the risk of my position. If I wanted to decrease the risk, then I might be a little more aggressive in making a market for an order that would do that. I was willing to give up a bit of theoretical edge to get my risk in line. For example, if my position was overall positive or long vega, and I wanted to make it less positive, then when an order came in to buy a calendar spread, I would make my offer a bit lower to try to sell it. A short calendar has negative vega, so if I sold it, my overall vega would become less positive.

As a retail trader, you can't really do that because you can't make markets and you don't see the order flow coming into the pit. But what you can do is bias your trades a bit. Let's say you have positive or long vega in your portfolio because you're long a bunch of calendar spreads. If volatility is lower, calendar spreads would be less expensive. That might fit your trade criteria, but if you bought more calendar spreads and your vega became more positive, then you'd be adding to your risk if volatility dropped. You might want to pass on buying more calendars. Instead, maybe you'd look to sell iron condors that have a low delta and negative vega. At lower volatility, the credit for iron condors would be lower, so you might not do too many of them, but they would partially offset your portfolio's positive vega. If you were going to make a directional speculation, you could sell a vertical—call or put, depending on your bullish or bearish bias—which would create deltas and negative vega. Alternatively, you could roll some of the short front-month options in your calendar spreads to a further expiration. That would reduce the amount of positive vega in your portfolio.

If you have a stock portfolio in that same low-volatility environment, you're at risk if the market goes down. If that happens, it's also possible that volatility would rise. As a way to reduce some of your portfolio's positive deltas and get positive vega, buying long out-of-the-money puts would generate some negative deltas along with positive vega. Long out-of-the-money put verticals could be less expensive than long puts, but would generate fewer negative deltas and positive vega. Long out-of-the-money put calendars would generate even fewer negative deltas, but could generate more positive vega. There's no “right” answer. There are only choices that affect your portfolio in different ways.

Diversification has a similar meaning for both traders and investors. Either way, what you're really doing is keeping your portfolio nimble. However, “investing” for the short term, as traders do, requires a different set of skills than simply understanding correlation between stocks, bonds, and cash products to weather a storm. With practice, you can finely tune the risk of your options portfolio to match your risk tolerance and any speculative bias you have. This will also let you structure your portfolios with more discipline. Rather than entering trades as discrete speculations, you see any individual trades as pieces of a broader portfolio. Any new trades would fit into and change the portfolio a certain way.