Post feedDiversification
Did anyone catch the exchange on yesterdays comments?
Enough said.
In response to the comments there is a question lingering about diversification. Specifically about using put options to hedge your portfolio. There are some great posts about this topic in my archives, but there over 500 posts on this monster now and I know you are as excited to search for them as I am excited to re-write them. So I will take one for the team.
Let's start with a definition of diversification...
"A risk-management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated."
Read that a few times and you'll get the idea. This is a method of smoothing portfolio risk coming from a wide array of ideas and not always going to be a perfect system. As option traders you can diversify your individual trades by selecting non-correlated instruments and you can diversify against the market with trading the upside of it along with the downside. You can buy tons of calls, and hedge with a bearish position on the indices. You can also diversify by using multiple strategies. You can take directional trades and non directional trades. In fact I recently slept through a presentation given by a particular brokerage about beta weighting your portfolio, neutralizing your position delta, creating a long theta position, etc and even though I want to puke over the idea.... it is also a form of diversification.
There are so many ways to accomplish this feat. It is like making money in the market. There are so many ways I can do it, but I am going to pick the method that I feel will be the path of least resistance for me. I can listen to others tell me how they are doing it, but that doesn't mean I will be any good at what they do. So I will know what the choices are and pick the path of least resistance.
I talk a lot about taking bearish trades against the trend of the market. Why? Because I believe in the trends of what I trade. If I am not trading the "market" then I don't worry about it's trend. However if I am trading ABC, then I focus on it's trend and respect the fact that the market is the overriding factor that could influence it.
As I diversify with bullish and bearish trades, I am also reducing my exposure to a change in direction by the market. For anyone trading over big market corrections, it was nice to have these alternate positions pick up the slack for your other trades, right? That is the idea.
With that being said, is there a real trick to diversification? Is there a secret recipe to buying puts in an incredibly bullish market?
Yes.
The secret is, you need to find stocks going down. Apparently this is easier said than done. However when you compare notes from various traders, plenty of people made great money on some of the bearish ideas here, while others lost money. The difference sounds like entry and exits. The stocks went down, yet profits ran dry. It's a bull market. There is a lot to be said for picking the next stock that will drop. It goes beyond fundamentals, big chart rank, blah blah blah. Find the downtrending stocks poised to drop and keep your risk in check.
I also get the question of how much of your portfolio should be dedicated to this, what percentage bullish trades versus bearish trades should one have, etc. I feel uncomfortable managing others portfolios when I do not know the investment objectives, risk tolerance, or the amount of capital that is being invested. Who better to answer this question than the person steering the ship! I will admit that I do not have a hard and fast rule for diversification. I will add or subtract as I see fit. As long as I feel my exposure is in check, then I roll with it. I know some traders hate to hear this, but many need to hear that there is no magic behind it. I have issued a few comments in the past about being 70% bullish and 30% bearish in this market, and that will vary based on what I find and how the account is totaling. In a sideways market it is more like 50/50, and in a bear market it goes back to 70/30. I do not recommend that you do this, this is just how I do things.
In summary we understand why it is important to diversify, but each individuals execution of this task will have different results. I'll open this up for discussion here so feel free to chime in on what you think is important relative to this topic.
Recommendation: Leave a comment, I promise I will be nice :)
Long: Diversity!
Short: Similarity!
Jeff:
Words cannot express the gratitude that we all feel for the time you take to train, advise and improve morale for this great group of traders you have assembled.
thanks
Don Vogel
Posted by
Anonymous |
6/05/2007 10:42:00 AM
Jeff,
Is forex market trading could be considered as one way diversification? Let me rephrases my question, is my diversification choices should only be with in on the equity market (stock and derivatives) ?
Thanks
Kas
Posted by
Anonymous |
6/05/2007 11:00:00 AM
Kas,
Nice catch! Trading currencies is a great method of diversification. In fact we discuss several ETF's that track exchange rates on the marketcast if you haven't traded in the forex market yet.
Posted by
Option Addict |
6/05/2007 11:06:00 AM
I love the pie chart!
I diversify by having no more than 2 stocks in the same industry, at max 3 (but that's rare) with my position sizes smaller if I do have 3.
I hold 6 or 7 stocks at most with 10-15% of my total investment capital in each trade. Thats the only way I can keep my emotions under control and keep up on the info on each stock. Then I just look to replace the non performers.
Does anyone have an opinion on my diversification?
Hey Jeff, just wondering if you are wearing those plaid shorts today. They make me smile. I wish people did that here in NYC. So much black. I just looked as what I was wearing today. Black. Gotta change now.
SusanFromManhattan
Posted by
Anonymous |
6/05/2007 11:18:00 AM
Thanks Jeff for your work on the blog today. Great stuff on diversification. The wonderful thing about this way of investing and this blog is diversification ... SO many varied opinions and most could be right. The bottom line ... hopefully ... we are all making some money in this market. We for sure are 'fine tuning' in order to do so and each post you put up helps us examine how we do what we do .. THANKS for that!
Have a great day folks ... How about X holding it's on in the midst of this little pullback today? "the tape has the answer" :)
Posted by
Benton |
6/05/2007 11:21:00 AM
Jeff, this is a brilliant and succinct post. You are a great writer. Thanks for taking the time.
I think it's important for all of us to remember patience, which makes a big difference psychologically if you trying to accomplish counter-trend diversification. It's easy on the up days to think "man, I would be making so much more if I weren't losing money on those puts" and that can be frustrating. But that is taking all of the trades and forcing them into a one-day time frame for analysis. But trades aren't one day operations. We have to see each trade's potential outside of the day to day.
Again, the thing that has helped me so much is what I learned from you about stepping back and seeing the bigger picture. My puts have all been pushing the lines for the past several days, but they've been holding. And today, they're all finally breaking down. Patience pays off and it's the only way to make a counter-trend diversification strategy work, in my opinion.
Posted by
Tim |
6/05/2007 11:22:00 AM
As always - thanks to Jeff and all the bloggers.
I too try to diversify by having bearish positions in stocks downtrending in a bull market and vice versa. However, I recently got hammered when my bearish positions actually reversed and turned up when the market turned down. So, when selecting stocks that go against market trend I decided to start looking at Beta and trying to select stocks on with a negative Beta.
Questions:
First, does that logic make sense? Secend, where in the world is Beta on the new website? I knew right where to look on the old site but now I can't find it.
Thank you
Brent in San Antonio
Posted by
Anonymous |
6/05/2007 11:29:00 AM
Susan,
I am unequipped with my fashionable shorts today, but there is plenty more where that came from. If you ever stepped inside my closet, you'd experience all kinds of emotion.
Brent,
Beta is on the "Financials" page. I don't use it, but that is where you'll find it.
Posted by
Option Addict |
6/05/2007 11:37:00 AM
X is flying
Posted by
optionfanatic |
6/05/2007 01:32:00 PM
Hello Everyone,
With most of my positions bullish and a belief that the market is over-extended, I have found some peace of mind in buying front month, slightly out of the money puts on the Diamonds (DIA). I expect to lose the full premium. However they are inexpensive and it acts as a nice hedge in the event of another 500 point debacle like a couple of months ago. I chose the Diamonds, because it appears to be several hundred points away from a firm level of support. In the event of a massive correction it should move nicely to the downside. This way I don't have to worry about finding bearish trades (although I still take them where I can get them). Ulitmately, the premium loss is only a small percentage of the gains from the bullish positions and I don't have to worry about waking up at 6:30 every day to see if the market is tanking.
Joel R.
California
Posted by
Anonymous |
6/05/2007 01:48:00 PM