Diversification for Option Traders

07/27/2012 9:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Josip Causic goes way back, to the high seas, to show how the diversification strategies used by traders centuries ago are almost exactly as valid today.

This article will address the importance of diversification among instruments when trading options. Although there can be various types of diversification, including using different option strategies, the purpose here is to discuss diversification among underlying products.

I found the following e-mail in my mailbox from an Online Trading Academy newsletter subscriber: “Hi Josip, I just started dabbling with options, and don’t know where/how diversification fits in with options. After all, I could just lose what I paid for the options, right?”

This e-mail indicates that the student trades only long options, either a long call (+c) or a long put (+p). In such a case, his assertion is accurate. However, there is a need for deeper understanding of the market and the products that are being traded if one seriously wants to trade for a living.

One of the easiest ways to start building a base of knowledge is to start with the simplest and most fundamental principles. How does the stock market operate? Although I do not intend to spend the rest of this options article on an in-depth explanation, a short one will be provided.

After the discovery of the New World, European countries would set up new colonies with the goal of extracting valuable goods and bringing them back home in order to earn profit. However, bad weather, poor navigation, or even pirates could pose a threat to these enterprises.

To offset these possible setbacks, the ship owners would find a number of investors and sell them part ownership (stock) of these enterprises. The new stock owners who helped to finance the voyage’s costs would, when the ships returned, share the profit according to the size of their share holdings.

To help increase the chances of success, some investors would invest in multiple enterprises, several ships at the same time. In such cases, their risk was spread, hoping that at least one ship would safely return and provide a payback greater than their initial investment.

The Dutch East India Company took this simple concept to another level by allowing the investors to invest in the entire fleet, minimizing the risk through diversification. It is from there that the whole stock market gradually evolved. The New Amsterdam Exchange is the humble origin of the NYSE.

Similar to the 16th century Dutch investors, I have “diversification” on three of my option trades. Although diversification has multiple levels, I am still using the most archaic and primitive example in which three uniformly built ships (Iron Condors) are on the same voyage (the same duration).

The figure below shows the European S&P 100 Index in a symmetrical triangle going into the week of July 4. The assumption was made that not much price movement would take place during the low volume week and that most likely the weekly bar of that week would still be contained within the triangle, and within the two horizontal lines.

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Next: The technical situation...

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The technical situation on the S&P 500 Large Cap Index (SPX) and Russell 2000 Small Cap Index (RUT) was very much the same; there were symmetrical triangles on both. Hence, basically the very same Iron Condor trades were placed on all three of them.

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The logic behind this is that there would have to be some major “storm” or unusual event that could make all three of these ships sink on the same expedition. Yet before discussing the adventure of the voyage, let us address the potential profit that was about to be collected if everything worked out smoothly. The table below, Figure 3, shows the premium that was taken in for each of the three traded vehicles.

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The storm, or unexpected event, took place one day into the voyage. The positive news from Europe caused all three underlying to rally. Yet just like sailing ships that have a strong wind in their sails, they could not all sail at the same speed—some are faster (more volatile) than others.

So was the case with these three Iron Condors. All three ships were taking in water during the storm, but some at a more alarming level. RUT was the most problematic one; however, let us go through them each one by one.

The first listed Iron Condor on the XEO was described in a previous article. The rally caused the XEO to take water in, with the 620 sold call being threatened, and a Butterfly was placed on it. Click here to read all about it.

The second one, RUT, was in a much worse shape. Due to the volatile nature of RUT, a different type of repair (than the Butterfly) was applied to it. Rather than abandoning the ship at max loss, an additional ship was sent on a rescue mission (knowing that both could be lost).

Explicitly, an additional Iron Condor was placed on RUT outside of the existing strike prices. Hence in the case of RUT, the original IC failed to stay within its ranges, but the latter one did stay. The combined result was not a profit, yet reduced the loss by the credit received from the second RUT IC.

The third one, the SPX, could be looked at as the flagship. Its sold strike prices were so far out of reach that the flagship was never seriously threatened at all. Below is the outcome of the expedition.

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Back in the 1980s, there was a song, “Two Out of Three Ain’t Bad” by Meat Loaf, and that is exactly the outcome of these three ICs. As the song points out, 66.6% winning is alright.

To read the conclusion of this article, click here.

Josip Causic is an option trading instructor for Online Trading Academy.

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