Portfolio Theory for the Little Guy

You may remember astronomer Carl Sagan’s signature line “billions and billions” rolling musically off his tongue. He was usually referring to stars, galaxies, or something else equally mysterious in outer space. In finance, “billions and billions” often refers to the amount of assets portfolio managers run. You know: “Joe Schmoe, portfolio manager at Great Big Asset Management, with X billions of dollars under management.” This may lead people to think that portfolio theory is only for Mr. Schmoe and his billions. Well, not necessarily. Portfolio theory can be for the rest of us, too—investors and traders, big and small.

Just What Is Portfolio Theory?

Then, there are systematic and unsystematic risks. Systematic risk is when stocks are pulled up or down by the overall market. Unsystematic risk is company-specific risk like earnings, news events, corporate uncertainty, and so on. You can reduce unsystematic risk with diversification, but you can’t reduce systematic risk in the same way. That’s because theoretically, all stocks are impacted by the overall market to some extent. You manage systematic risk by allocating your account’s available capital among stocks, bonds, cash, and other assets. When you build a portfolio with many stocks, you reduce the unsystematic risk but maintain the market’s theoretical return.

How many individual stocks do you need? If you trade too many stocks, your portfolio can become unwieldy. You could achieve diversification with fewer than 30 stocks, if each one was in a different sector. You could also make your portfolio more diverse as your experience allows, or as interesting investment opportunities present themselves.

Two Considerations

Also, when you invest in a single index, you have less flexibility in choosing strategies than with individual stocks. Maybe you want to sell some calls against your long index to reduce your position’s breakeven point, or generate income in exchange for limiting upside potential. Index options often have lower implied volatility (“IV”) than options on individual stocks. That makes sense because indices have theoretically lower unsystematic risk than individual stocks. With lower IV, all things being equal, the option premiums are lower, too. That means you might collect less premium when you sell index options.

But if you don’t have much money in your account, how can you buy a bunch of stocks to create a portfolio, especially when some of them cost hundreds of dollars per share? If you buy 100 shares each of even just a few stocks, it can add up.

A Spread Alternative

There’s another possible portfolio path: option spreads. Suppose you’re trading a smaller account. Ideally, you’d want a bullish portfolio composed of long delta positions in stocks in order to reduce unsystematic risk through diversification, have flexibility in choosing stocks or weighting sectors, or employ a variety of strategies depending on volatility and your personal risk tolerance.

Here are three bullish strategies you might consider when creating a diverse portfolio. Capital requirements for these strategies are typically less than what you’d need for similar exposure to stock, and they provide the opportunity to build a portfolio of 30 stocks or fewer.

1. Long call vertical
A long call vertical is a long call at a lower strike and a short call at a higher strike in the same expiration that carries a debit. It’s a bullish strategy, with a max risk of the debit paid if the stock is below the long call strike at expiration; a breakeven price of the long call’s strike price plus the debit; and a max potential profit of the difference between the strikes minus debit when the stock is higher than the short call strike at expiration, not including commissions. You might consider long call verticals as a bullish strategy when the stock’s volatility (“vol”) is lower.

The debit of a long vertical depends on the stock’s price. For example, the debit on a long 200/205 call vertical on a stock trading at $202.50 might be $260, while the debit on a long 100/102 call vertical on a stock trading at $101 might be $120. You could potentially have a portfolio of long call verticals in 20 individual stocks at different price levels, with a total debit (not including commissions) of less than $5,000.

2. Short put vertical
A short put vertical is a short out-of-the-money (OTM) put and a long further OTM put in the same expiration that delivers a credit. For example, with SPX trading at 2,700, a short put vertical might be to sell the 2650 put and buy the 2600 put with the same expiration. It’s another bullish strategy, with a max risk of the difference between the long and short put strikes, minus the credit received if the stock price is below the long put’s strike at expiration; a breakeven price of the higher put strike minus the credit; and a max potential profit of the credit if the stock is higher than the short put strike at expiration, not including commissions. You might consider short put verticals for a bullish strategy when the stock’s vol is higher.

The amount of money you need to establish a short put vertical is the difference between the strikes minus the credit. The capital requirement for a short 190/195 put vertical on a stock trading at $200 might be $300, while the capital requirement on a 96/98 put vertical on a stock trading at $100 might be $140. Again, you could potentially have a portfolio of short put verticals in 20 individual stocks at different price levels with a total capital requirement (not including commissions) of less than $5,000.

3. Long call diagonal
A long call diagonal is a long at-the-money (ATM) or in-the-money (ITM) call in a further expiration, and a short OTM call in a closer expiration that carries a debit. It’s another bullish strategy, with a max risk of the debit paid if the stock is below the strike price of the long call at that long call’s expiration. Because of the potential to roll the short front-month option to a further expiration and take in a credit to reduce the diagonal’s net debit, the breakeven price and max potential profit aren’t always defined. Yet, without any rolls, the diagonal has a profit of the difference between the long call strike and the short call strike minus the debit, if the stock is higher than the short call strike at its expiration, not including commissions. You might use long call diagonals as a bullish strategy when the IV of the long call is lower, and the IV of the short call is higher. This can happen around earnings or news events.

The debit of a long call diagonal depends on the stock’s price. For example, looking at long calls with 90 days to expiration, and short calls with 30 days to expiration, the debit on a long 200/205 call diagonal on a stock trading at $202.50 might be $450, while the debit on a long 100/102 call vertical on a stock trading at $101 might be $290. The capital requirements for diagonals can be higher than for long call verticals or short put verticals. But you can think of long call diagonals as a lower-capital-requirement alternative to covered calls (long stock and short call), where the long option takes the place of the long stock.

Consider two caveats. Using option spreads instead of stock means you don’t collect any dividends. Plus, you have to deal with rolling, or closing these spreads at expiration, which can incur extra commissions and fees. You might also have to be more attentive to option spreads than long stocks. But the lower capital requirements of spreads means you can potentially create a more diverse portfolio than with long stock. Like everything in trading, it’s a trade-off.

Add a Personal Touch

Being your own portfolio manager in some sense means looking at your assets together. One feature of the thinkorswim® platform from TD Ameritrade is the ability to see all your positions—stocks, options, funds, futures—in one display. By default, you’ll see all your open positions in the Position Statement section on the Monitor tab for a single account (Figure 1). 

You can see all positions from multiple accounts, like margin accounts, IRAs, and joint accounts, by selecting “All Accounts” from the dropdown menu at the top of the platform.

So, would you like to play “portfolio manager”? You can experiment with option spreads to create a portfolio using a small percentage of your total assets and compare its performance to other products. It’s all about having choices, being realistic about the size of your trading account, and finding ideal strategies relative to available capital.