Diversification Using Options

10/21/2015 8:00 am EST

Focus: OPTIONS

For the benefit of all newbies just starting out, options instructor Russ Allen, of Online Trading Academy, highlights the benefits of diversifying through the use of options and outlines how a trader—for a very small investment—can own positions in some very high-priced stocks.

One of the main features of trading with options is that you can get a large amount of leverage. For a very small investment, you can own positions in some very high-priced stocks. Since each position takes only a small amount of money, an investor who has (or cares to risk) only a small amount of risk capital can diversify among many such positions.

Diversifying risks is always safer than concentrating them. It is the nature of markets to boom and then bust. If you have all your money in stocks and the stock market has a bad year, then you have a bad year. But if you can diversify among several positions in different asset classes whose boom-and-bust cycles do not coincide, then it should be rare for all of them to have a bad year at the same time. With options, you can afford to diversify more widely.

Here is a chart that demonstrates the benefit of diversifying. It is a percentage change chart showing the relative performance of five different assets over the last ten years. The black horizontal line is the zero percentage baseline. At any point in time where the chart for an asset is above the zero line, it had a positive cumulative return to that point. Below the line means a negative cumulative return.

chart
Click to Enlarge

The assets shown are exchange-traded funds (ETFs) that track the following assets:

  • SPY (Red)—Large-cap US Stocks
  • GLD (Gold)—Gold
  • QQQ (Magenta)—Large-cap NASDAQ Stocks (largely US tech stocks)
  • TLT (Green)—Long-term US Treasury Bonds
  • XOP (Black)—Oil & Gas Exploration and Production Index

Notice these things about this chart:

  • After ten years the cumulative returns are quite different. They range from minus 2% (oil) to plus 176% (QQQ).
  • During the ten-year period each one of these ETFs spent at least some time as the best-performing one and some time as the worst-performing one.
  • They are generally un-correlated, except for SPY/QQQ. Aside from those two, their charts show little relationship to each other.
  • There was no time when all had a cumulative negative return at the same time (i.e. all below the horizontal black zero percentage baseline).
  • Therefore, if we could hold several of these assets at all times our chances of avoiding a disastrous year at any one time are much smaller.

NEXT PAGE: A Case in Point

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What is true over a period of years is also true over shorter periods in this case. There is rarely even a week when all of these different asset classes show a loss at the same time.

With options, we can afford to hold positions in several assets at the same time with a small amount of total capital involved.

Let’s look at SPY as an example of having most of the benefits of ownership at a lower cost. On October 15, SPY was at 202.35 per share. One hundred shares would cost $20,235. If we had bought SPY on that day, and it then went up in price in the next three months by 10%, we would make $2,023. On the other hand, if it dropped by 10% we would lose that same $2,023.

With the simplest possible options strategy, just buying call options on the SPY, we could have had just as good a profit potential and less risk for much less money.

For $770 per contract (covering 100 shares), we could have bought call options to purchase SPY at $203, good until March 2016. For $1540, we could have bought two of these calls. With this position, if SPY should go up by 10% in three months our profit would be about $2500, a little more than the $2,023 from the outright purchase of the SPY stock. If, on the other hand, SPY should drop by 10%, the call position would lose about $1500.

So, the call position costs a fraction (8%) of the cost of the purchase of the shares; and would make more or lose less than the share position in case of large moves either way. Best of all, the total maximum loss should SPY drop to zero was just the $1540 paid for the calls. This was far better than the $20,235 that the shareholder could possibly lose.

With only $1540 at risk in this one position, a small investor could afford to diversify among several different ones at any one time, spreading their risk. Other positions could be taken in some or all of the other asset classes at the same time.

The purchase of calls is just one way in which we can make a trade that benefits from price movements with little capital at stake. There are many others.

By Russ Allen, Instructor, Online Trading Academy

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