Every trader knows that trades can move against a position. With wise analysis and careful selection, the market risks can be reduced. But if all your options are written on stocks in the oil and gas sector, or retail, or Internet companies, a sector-wide downward cycle could hurt all your positions. Options traders, like all traders, will improve their success and reduce market risks by being aware of the need for diversification in terms of market sectors, specific companies, options strategies, and timing of trades with many other things in mind (ex-dividend date and earnings announcements, for example).
Diversification is not well understood. To many, simply buying shares of several different companies is adequate. However, if all those companies are subject to the same market and economic forces, are you truly diversified? Of course, you are not. It’s more than just expansion of sectors that defines true diversification. Many dissimilar sectors face the same types of market risks. To diversify, you need to diversify market risks. This means options traders need awareness of cyclical forces for companies, not just for options strategies.
For example, if you own shares in four of the major oil companies, all of them are going to rise and fall due to the same changes in the market, commodity price, OPEC decisions, and more. This is not diversification; in fact, it is just the opposite, a concentration of capital in a narrow area. Some options traders, aware of the leverage options provide, tend to ignore this and to fall into the belief that market forces for a company do not affect the valuation of options or the change in option premium. Just as stock investors experience varying levels of market risks, options traders do as well. It is important to be reminded that options are called derivatives because their value is derived from movement in the underlying security. This means there is a direct relationship between historical volatility and option valuation.
Many traders ignore historical volatility, favoring implied volatility (IV) of the option. But this tests and predicts option volatility alone and not the underlying volatility. Because IV is based on estimation, it is less reliable for diversifying risk than the more precise measurement of historical volatility.
For many devoted options traders, the suggestion that implied volatility should not be considered in assessing risk is a form of heresy. But it is a rational point to make. Here’s the point: If you are not diversified, market risk can have an immediate and negative impact on your options trades, no matter how much prediction from IV is involved. Even if you accurately estimate future IV, a key point to keep in mind is that IV forecasts levels of risk, but not direction of price movement. An option may react to stock prices in a low or high volatility level; but IV measures degrees of change, not whether prices move up or down.
To some traders, this comes as a surprise. A popular assumption is that tracking IV allows a trader to predict whether to be bullish or bearish. It does not.
Diversification is not the answer, any more than estimating volatility ensures well-timed trades in the right direction. A lack of diversification exposes traders to market risk which might be greater than their risk tolerance finds acceptable; and that is the problem. If you could find “sire thing” in an options trade, you would not have to worry about diversification. It would be possible to put all your money in a single trade and just collect profits.
Is this an unlikely scenario? Not at all. For example, many covered call traders believe they are not exposed to risk in any form. These are foolproof trades.
The truth contradicts this assumption. If the underlying price falls below your adjusted basis (price of stock minus option premium received), you have a paper loss and you must either wait for the price to recover or look for a recovery strategy. On the upside, maximum profit is limited to the premium you received for selling the call, meaning the lost opportunity of a rapidly advancing underlying price should be kept in mind as well.
Covered calls are not foolproof, meaning the need for diversification must be expanded beyond spreading money around among different companies. It also requires diversification of options strategies and risk exposure.
The lack of diversification is subtle. For example, owning shares of different companies not in the same industry may be equally non-diversified. Just because a portfolio consists of stock in companies of different market sectors, does not mean the portfolio is diversified. By the same observation, limiting yourself to only one strategy represents an equally serious form of non-diversification. For example, if all you write is a series of covered calls, a marketwide bull trend could lead to exercise of all your positions – and to significant lost opportunity.
True diversification takes many forms. If you limit the form of diversification to stocks, make sure the sectors involved are not subject to the same influences. Don’t overlook cheaper and often forgotten stocks, either. Your profit potential can be enhanced with quick and easy ideas for these companies. Beyond direct ownership of stocks, you can diversify by:
Buying shares of ETFs or index funds and writing options on those positions.
Diversifying by degrees of risk, for example combining selection of strong value investments with less speculation in more volatile growth stocks, again opening covered options on this portfolio.
Combining stock ownership with option speculation, exposing you to potential capital gains from market activity along with current income.
Dividing a portfolio among stocks, bonds, commodities and real estate. (And by the way, you can invest in any or all of these without owning directly, if you seek a specialized ETF with ease of trading and built-in diversification within each ETF).
- Trading options in place of stocks for maximum leverage and risk reduction, and opening calendar spreads to hedge market risk in existing equity positions.
In summary, just be sure that the various baskets contain different kinds of eggs. Most traders and investors know better than to put all their eggs in one basket, but if you are carrying all the baskets at the same time and you trip, don’t all the eggs break?
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.