How to Trade Options – Diversified Trading Stock Options but Still Suffering Concentration Risk

Applying a more complete definition of diversification can help retail option traders diversify their portfolio
profitably, beyond equities.

A buddy started online options trading from home, in the last 6 months. He was trading a mix of Verticals,
Calendars and Iron Condors using highly liquid Indexes but was failing to get consistent profits. Naturally, I
asked, “Which Indexes?”

He answered, “DJX, DIA, MNX, QQQQ, RUT, SMH, SPY and XSP. I’ve incorporated broad-based Indexing
across large, mid and small-cap stocks to remove single stock exposure. Having learnt how to trade options
with Verticals, Calendars and Iron Condors, I’m spreading across these various Indexes. I’m being careful
with money management, 2%-5% per trade, I’ve diversified risk, yes?”

No. He has partially diversified a portion within his portfolio; but, is still suffering concentration risk. All he
has really done is allocate capital across multiple products, using various option spread types; yet, all his
trading capital is stuck in equities.

In choosing the MNX, QQQQ, SMH, SPY and XSP, there is a duplication of stock components in these
Indexes: for example, AMAT (Applied Materials) is a component of all 5 Indexes. Bear in mind the MNX and
the QQQQ are both smaller versions of the Nasdaq100 Index, the only difference being the MNX is an
European styled cash settled Index and the cubes (QQQQ) is an American style stock settled Index.
Another example, Apple (AAPL) is a component of the MNX/QQQQ and SPY/XSP - both the SPY and the
XSP track the S&P 500, the SPY is American style stock settled and the XSP is European style cash settled.
Duplication is not diversification. Even if you allocated capital to the smaller versions of the Dow: DJX, the
European style cash settled version of the DIA which is the American style stock settled version. Moreover,
if you extended capital allocation to trade the RUT, thinking you are diversifying into small-cap stocks and
away from large-caps, you just sunk more of your trading capital into equities. Again, you cannot achieve
diversification by adding more capital in the same asset class. That is concentration risk in stocks. Do not
confuse asset category (market capitalization) with asset class.

Why bother diversifying across Asset Classes? To answer this question, I’ll use an example of a well
known traded stock: Apple (AAPL). You won’t need to understand Fundamental Analysis to follow the
reasoning.

Summarizing a financial extract from its Annual Report, Apple has almost ~30% of its Net Sales distributed
across: UK, France, Germany, Spain & Ireland and Japan. Apple’s customers in Europe are paying in
EUR/GBP and customers in Japan will be paying in JPY. Even though you are trading Apple directly as a
US parented firm listed in the US and the currency of the parent is USD denominated, the company has
currency exposure to the EUR/GBP and JPY arising from operating sales entities in those jurisdictions. So,
you are already exposed to currency and geographic risks by choosing Apple as a product to trade, even
though you are constructing an option trade on the stock.

So, it makes sense, rather than have these exposures wrapped inside the stock, where you are
subordinating non-equity risks to the stock, to deliberately surface the risks in Geography, Commodities and
Currencies. Then, isolate these elements and trade them directly using optionable Geographic ETFs,
Commodity ETFs and Currency ETFs.

Is there an example of a consistently profitable and diversified portfolio to see the merits of trading
options beyond equities? Yes. Follow the link below, entitled “Consistent Results” to learn how to trade
options using a multi-asset class set up. Notice how the profits step up gradually, from the mid hundreds to
the higher hundreds; then, from the higher hundreds into the thousands. While, the losses are contained
within the mid to lower hundreds. Diversification to trade options in non-stock asset classes using
Geographic ETFs, Commodity ETFs and Currency ETFs, deliberately dilutes the concentration risk in the
portfolio’s P/L.

If you are puzzled, yet intrigued, you may well ask, “I don’t need to Beta-weight the Deltas of my option
positions; then, hedge using Futures? Do I need to adjust my existing positions by embedding single
options; or, morph the original spread into a hybrid option strategy?”

No, is the answer to both questions. Just as it would not make sense within stocks to say Beta-weight a
company like GE to the SMH (Semiconductors Holdrs), there is even less sense to Beta-weight a broad-
based Index like the SPY to an Emerging Market ETF, Commodity ETF or Currency ETF. Diversification is
designed to break the commonality in correlation between the asset price movements of products, in the
retail trader’s portfolio structured for online options trading. Adjustments fail to provide the consistency in
laddering up the profits as seen in the portfolio, because an adjusted trade often fails to restore, let alone
improve the original profile of the trade’s volatility and probability that was bought or sold.

How is this possible? Volatility can be added to/reduced from the portfolio, as not all Asset Classes or
Sectors or Individual Companies or Countries move up/down in value ALL at the same time; and/or,
ALL at the same rate. It is the volatility level across various asset classes that is targeted for diversification.

To conclude, here’s the point to reflect on. While diversification alone does not guarantee a profitable
portfolio, do you think you are diversified trading stock options but still suffering concentration risk?
Think deeper.

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Thanks for reading my article,
Clinton Lee.
Founder, Home Options Trading: a uniquely retail-focused option-centric trading firm.

Please see Consistent Results at http://www.homeoptionstrading.com/consistent_results/, displaying

the Model Portfolio's Performance YTD, updated each month-end. The portfolio models a typical retail
option trader's account up to USD $50,000. Here's the stats in summary:
 Return: Profit/Start of Year Cash Balance = $91,593/$58,380 = UP 157%.
 Win/Loss Probability = 60/68 = 88.24%.
 Performance Ratio = (Win/Loss Probability) x (Average Win/Average Loss) = 88.24% x $2.99 = 2.64.
 Positive Expectancy = (Win Probability x Average Win) - (Loss Probability x Average Loss) =
$1,347 per trade.

Preview an original 55 hour video-based course for online options trading from home, at
http://www.homeoptionstrading.com/original_curriculum.html
Purchase the curriculum and receive an $800 options basic course as a Bonus!

Clinton's career spans 16 years of treasury, finance and banking across Hewlett Packard, JP Morgan Chase,
Citibank, Royal Bank of Scotland (previously ABN Amro); and, is currently a Senior Liquidity Advisor at Bank
of America in its Global Treasury Services division. Despite the years in the finance/banking industry, it did
not help him directly grasp online options trading from home.