Are You Missing the Forest for the Trades?

Assume you've achieved the expertise of a trading machine. You know the strategies. You're on top of the market. You see a stock move, check its vol, put on a trade. You manage your capital and risk efficiently on each one, and have a solid reason for every decision. That pretty much defines an experienced, engaged trader. But there's one thing even veterans can miss. In the daily process of finding and placing trades, sometimes the trader forgets that all those trades add up to something unique. They create a portfolio.

See the Big Picture

Long-term investors often create portfolios around different ratios of asset classes. An option trader doesn’t necessarily think about asset classes, but rather a series of verticals, calendars, straddles, and so on, in whatever stock or index presents potential opportunities. Each strategy, for example, might be used within certain parameters for risk, probability, theta, and implied vol. And even though each of those strategies may make sense on an individual basis, an option trader should step back and take a look at the entire portfolio she’s created. Because quietly, in the background, the portfolio itself might be building up delta, vega, or even theta to undesirable levels. In a word, the sum of the parts creates a whole with its own rules.

Sounds a little like Frankenstein’s monster, right? Well, stay away from the percolating chemicals and lightning rods and use the tools that the thinkorswim^® platform by TD Ameritrade provides, like the beta-weighting tools on the Position Statement section of the Monitor tab. Why? Because that’s where all your current positions along with various parameters are visible.

First, look at beta-weighted greeks. Click on the “Beta Weighting” box and enter the symbol for an index that roughly covers most of the symbols in your position. For example, are most of your trades in large-cap stocks? Then S&P 500 Index (SPX) might be a good beta-weighting symbol. Small-cap stocks? Russell 2000 Index (RUT) might be a better choice.

Flatten Delta

The first thing to review is your portfolio’s beta-weighted delta. That reveals how many deltas your portfolio theoretically has in terms of the beta-weighting index. For example, suppose a portfolio shows a beta-weighted delta of -127 (see Figure 1). Theoretically, the portfolio would lose $127 if the SPX rose $1, and it would make $127 if the SPX fell $1.

Assume the SPX might move up or down 20 points or more, and the short 127 deltas might be more risk than you’d like. So, how to reduce it? There are a couple of potential approaches using index options. Long delta strategies like long call verticals and short put verticals in SPX would potentially reduce the short portfolio deltas. To what degree depends on which vertical you choose, and how many were traded. You can simulate adding long delta SPX positions to your portfolio on the Analyze page to see how much a particular SPX strategy would help reduce deltas. This is more of a longer-term delta reduction—meaning you may not want to reduce your portfolio deltas to zero, but just flatten them somewhat while still maintaining most of your bearish, negative-delta stance.

On the other hand, consider an index option strategy that would neutralize the portfolio delta more aggressively ahead of a major event. In that case, you might choose to take on greater risk on the index side—short naked puts, for example—where one trade could add enough positive deltas to take the portfolio delta from -127 to zero. It’s a short-term event and you’re on top of your positions. No naps allowed!

This is a tactic floor traders often use when they don’t want risk to get in the way of new potential opportunities that a big event might provide. And most feel it has to be a simple trade to execute—no complex spreads. The cool thing is that you can do this analysis the night before, and if you decide to, you can quickly incorporate it the next trading day if needed.

What if you look at the market and all you see are bearish opportunities? If you put on bearish trades, you would potentially only increase your portfolio’s negative deltas. Maybe you could try to find some bullish strategies by using scanning tools like Stock Hacker and Option Hacker to find stocks you might not be currently following. If you’re a contrarian trader, for example, you might try to find a stock near its 52-week low to investigate a bullish strategy. Or you could find positive delta trades with certain vol or stock-price parameters.

Drill Down

Maybe you don’t want to open any more positions. We’ve talked about balancing risk between individual positions—that is, keeping the beta-weighted deltas of individual positions roughly the same. Here’s another way to look at them. Sort your positions by their trade time, and think about taking off those you’ve held the longest—meaning, first in, first out. Why? As time passes, the conditions on which you based the trade might have changed. You may not want to hold a position that you wouldn’t want to establish as a new trade. Arranging positions by time, which you can do on the Position Statement, lets you take a hard look at the positions you’ve had the longest. Even if you decide not to close a position, you’ll want to at least review it and reassess the logic of the trade. Again, you can do this type of analysis outside of trading hours so it can become a potential plan for the next trading day.

Crush Time Decay

Speaking of time, that’s where the next step—portfolio theta—comes into play. The nice thing about portfolio theta is that anyone can add them together and not weight them. That’s because one day passing is the same no matter what’s being traded. And theta is a dollar term that measures the decay in the extrinsic value of a portfolio’s options. Theta, then, is in the same scale for all products, so it’s kind of self-weighting. All things being equal, the theta of an option in a higher-priced stock will most likely be higher than that of an option on a lower-priced stock. That’s why you can compare theta directly between trades without adjusting them again for underlying price, like you would do for delta.

For portfolio theta, what’s key is time to expiration. If the portfolio’s theta is $212, the portfolio would theoretically make $212 over the next day due to time decay, if nothing else changes. Generally, theta is highest the closer an option is to expiration. Is that positive theta high because most options in the portfolio are expiring in the coming days? Or are the options diversified over time, with some close to expiration with very high theoretical theta, and others further from expiration with lower theoretical theta?

By balancing theta over time, you avoid big theta swings as expiration approaches and passes, while attempting to diversify across events. If you see most of your positive theta positions clustered around one expiration, or around a significant news event, your short options might all go against you at the same time and wipe out your theta. You could attempt to roll short options to nearer or further expirations to spread theta out. Rolling those short options out to further expirations can preserve the same trading logic of the original position, while maintaining a steadier theta for your account.

A quick way to check for earnings events on a symbol is to project future dates on Charts. Click on the Style button on the Chart, then choose Settings from the dropdown menu. Next, click on Time axis, and find the Expansion area (Figure 2). Set it to 60, for example. That will expand the right hand side of the chart and let you see any event announcements coming up.

Neutralize Vol

Finally, check your portfolio’s vega. If it’s negative 938, that means your portfolio would theoretically lose $938 all else equal, if the implied vol of each option in your portfolio rose by exactly one percentage point. Vegas are added together, just like theta. The only warning is that the implied vols of the stocks and indices in your portfolio may not always move up and down at the same time. So, portfolio vega is typically a rough estimate. But if the market crashes and sends VIX through the roof, it’s possible that the implied volatilities of all symbols in your portfolio might go up, too.

If you have a lot of short vega, see where the VIX is. If it’s low, ask yourself if you want to be short volatility when the risk of a spike may be high. To reduce short vega, consider adding long options in further expirations to create calendars out of some short options. On the other hand, long delta trades in VIX options, like long call verticals, could also help offset losses if vol rises and hurts your short vega positions.

Just like hedging delta risk, identify the one trade—whether it’s a positive vega index trade or a VIX trade—that will potentially neutralize the short vegas if necessary.

Combat Risk

Keep in mind that all these adjustments incur commissions, so making a lot of them can drive commissions higher. But the goal of this exercise is to get you to step back, look at the aggregate delta, theta, and vega risks of your total portfolio, and create a plan to bring them back to where you’re comfortable. When you need the hedge, chances are the markets will be moving, and you’ll want to focus on that.

Tear a page from the market maker’s playbook. Do your homework the night before, and take action to attempt to manage risk and stop the bleeding when needed. Above all, consider all the moving parts of your book. Frankenstein’s shinbone connected to his knee bone, so he was careful to nurture them both.