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Ep 114: Diversification: Should You Diversify & the Ways to Diversify

Hey, this is Sasha Evdakov.

Today we’re going to be focusing in on diversification. You’ll see should you diversify and also a few different ways to diversify.

What is diversification?

A diversification in simple terms is a way to spread out your risk. When it comes to diversification, it all comes down to hedging.

And if you don’t understand what hedging is all about it’s looking at your risks or the positions that you have — and minimizing those risks.

If you have all your positions all going to the upside hedging or diversifying those things could help in case you get a significant market pullback. The thing is that not every position would go down the same rate or the same way.

Some positions may go up some positions may go down with the market, and that’s what diversification helps you out with.

The big goal behind diversification is to minimize the risk. There are some traditional ways to look at diversification, but I’m going to share with you some other variations and other ways to look at diversifications and how to minimize those risks.

Remember This Throughout The Lesson

As we go through this lesson keep in mind that we’re focusing on the risk management part for diversification. It’s not to diversify because it makes you feel good. It comes down to looking at diversification, and in case you get a market pullback, and you’re invested fully to the upside you’re diversified or hedged.

That way you minimize the risks. It’s not about feeling good. In diversification, there’s a point to reduce the risks.

Ways to Diversify

The methods of diversification are:

  • a position based diversification (most common)
  • inverse positions (GLD and SPY)
  • a time-based diversification (could be found on the same stock)
  • ETF based diversification (SPY and IWM)
  • Stock + Option mixed strategy (sell calls)
  • option strikes/positions
  • mixing option strategies

Let me go through a few of these different variations to show you how to diversify and how to see your positions by hedging these positions.

Disclaimer

Before we get started and moving into these examples keep in mind, these are examples. They’re not recommendations to buy or sell any stock or security. There are some risks involved especially tax consequences. Contact your financial advisor or your investment professional before making or placing any trades.

Getting Started With a Position Diversification

Here I have my thinkorswim platform up, so the first type of diversification that I want to share with you is a simple position diversification.

I’ll share with you how to do a simple basic diversification on positions. This is what most people think of when it comes to diversification.

If I buy Amazon (10 shares), it’s going to cost me about $7,000 for those ten shares. I’ll put those in, and now as you see, I should have those ten shares in Amazon. The problem with this is if Amazon tanks and goes down you’re losing your full investment.

You’re losing your $7,000 or whatever that you put in on the stock. That’s the case because you only have one stock and you only have one position.

Then you might have another company (ExxonMobil), and you can buy 30 shares of this one. Now all of a sudden I’m filled on both of these orders, and now I have Amazon and ExxonMobil.

As you can see between both of these, I’m diversified if Amazon goes down, but ExxonMobil is stable then at least my ExxonMobil position helps compensate for that.

It’s the same thing in reverse. If something happens in the oil companies then at least I have my Amazon position to counterbalance that.

This is something like a 50/50 split diversification. Now you’ll notice it’s a 30 share (ExxonMobil) and a ten share (Amazon) but Amazon, of course, is higher priced. You could say it’s slightly balanced.

In either case, you could continue and stack the third position on it if you wish. However, that’s a whole different game. In general, this is what most people think of when it comes to diversification.

Inverse Positions

The next diversification is inverse positions. For example, we’ll take SPY (10 shares).

When the market goes up, the spiders also go up. Now in inverse or contrary to this when the market goes up Gold goes down. And on the flip side when Gold goes up, the market goes down.

You could do the same thing with TLT – like the bonds. Or you could do something with the Gold. I could diversify this based on our inverse strategy. This is strategy number two where we’re looking at the SPY, and now I could go into the TLT.

I could buy the TLT, and I could hedge it this way. I could do 15 shares. Now I have 15 shares of TLT and ten shares of SPY.

These move inverse or the opposite. It’s not always the case. It’s not still going to happen in that way. Sometimes when the market goes higher, bonds can also move higher.

Sometimes when the market goes higher at the dollar or Gold can also move higher. But in general most of the time they should work a little bit opposite. That’s the case especially if you get a massive pullback, selling or an enormous pop.

That’s one way to do it. You could also do the same thing with the GLD.

If I buy 20 shares this is what we have right now:

  • Ten shares of SPY
  • 15 shares of TLT
  • 20 shares of GLD

If you look at these, you could see how I’m diversifying here based on inverse positions.

These are the opposite of what I usually am looking to move for the SPY. And you could do this maybe slightly on the Gold and perhaps somewhat on the TLT. Or you could have one position on the TLT or the Gold.

For example, you could have 100 shares on the SPY and only hedge or diversify maybe 20 stocks on the TLT or the Gold. It depends on how much risk level and how much hedging you want to do for your diversification.

Time-Based Change in Diversification

Let me reset this again to zero and reset these balances. Here what I could do is to cover a few of these. A time-based diversification it’s typically one position. I would generally do this maybe with an ETF. You could do it with a stock if you wanted to.

For example, we’ll use the SPY again. We get into SPY and buy ten shares to start. This is a starting point. We got filled on our ten shares, and now you can see we have ten shares on the SPY.

As you start looking at charts and as you look at the SPY itself you could see we’re moving to the upside. You could wait a week, two or five weeks depending on your position.

You could wait until a little pullback. Or even if it climbs higher, I’m diversifying based on time. It might be my next time that I’m getting into these trades or positions. I do another same batch of quantity, but I’m doing it a month later.

This helps average your risk. Hopefully, you get it somewhere in the 220 area or something to that effect. Now you may ask if the first ten go down or the first batch of shares goes down? Yes, it would, but remember you’re looking at a big picture to create a position.

And that’s what ultimately allows you to diversify. So you’ll still be getting a dividend from the SPY. Maybe I might wait perhaps a minute or two, and I could decide to diversify and get another ten shares or something to that effect.

That is possible, but that’s not a long enough time. But here is my next batch of 10 shares.

If you dig deeper into this, you could probably figure out your average price on the market. Here we did ten shares if you start looking into the orders. You could see right there I did ten on that price and ten on another price. That’ll help average your price down or better.

That’s what you’re doing when you’re doing a time-based diversification. You could do it on an individual position. And you could do it on an ETF like I’m doing right here. But the key is to diversify based on time.

Important Note: Some risks go along with it because you don’t know when is the low point. Let’s say the stock pulls back you don’t know if that’s the low point. You don’t know if it continues to going down lower.

However, if you have the long-term view in mind and you’re looking to capitalize from dividends and continue to invest and then getting those bounces ultimately that would be the plan.

You put in another ten shares and maybe within a year or two you get into your big position of 500-1000 shares depending on your account size.

ETF Based Diversification

The ETF based is pretty much what we’re doing right now. The SPY is an ETF. The TLT bonds is an ETF. You also have other ETFs like the Dow Jones which is the basket of the 30 stocks. But you also have the IWM.

All these are ETFs. If you’re getting started sticking to the SPY, the IWM or the EEM these are all ETFs.

You could say that your diversification is simply getting the Dow Jones and that is it. This is a basket of 30 stocks, and you’re looking at the Dow Jones. For me, if I was an investor and I want to put my money all in one spot, I would put it in the SPY. Just let it sit and forget about it.

Because that’s more 500 base stocks, you could do the IWM as well – this is more 3,000-2,000 stock ETF. It’s a more significant range of stocks, but the SPY based on the dividends that they pay I like that stability.

Since this has a lot of different holdings in it, it allows you to be diversified based on the holdings. When you’re buying this, you’re still basically looking for market movement to the upside. It’s always one position. You could use this hedge as we talked about earlier with the GLD or the TLT.

The SPY itself is an ETF which allows more diversification if you want one single holding. I know that for some people if they have a small account diversification can be a little more complicated.

If you have an account of $5,000, it’s a little more challenging to diversify. In that case, you’re splitting your assets, and you’re splitting the amount invested. This is a bit better for people with smaller accounts – depending on your account size.

You could still diversify 50/50 even with a $5,000 account. It’s that the absolute dollar value is still only $2,500 in the stock market. That’s not a significant amount of money in the market. The relative value to you personally it’s quite a bit of money.

That’s because we could still use it for a lot of different things. And when you diversify a $5,000 account, that’s still 50%-50%. The diversification on the level of percentage of hedging is still quite big.

If one of them goes down in a big way, the other one should help and compensate. Relative to your account in a relative basis it’s still a significant diversification. You’re diversifying based on 50% if you did two ETFs.

On the SPY if you didn’t have the account or the flexibility the amount of money or capital in there, you could do the SPY. And you should be okay there to start.

SPY Website – Check it For More Info

If we go on the spiders website you could see here based on the ticker the SPY it tells you all the different breakdowns.

It tells you:

  • fund characteristics
  • the Yields
  • index characteristics
  • index statistics

There’re a lot of things that it’ll tell you about it, but I’ll also tell you about the holdings -the weight of the holdings. You can see Apple is about 3% of the holdings and the shares held.

You can see it’s a mix of a lot of different holdings here – Microsoft, ExxonMobil, Johnson & Johnson. And it gives you a range for that diversification. There’re the charts, the graphs and you can see all those different things.

In either case, that’s another way to be diversified.

Options – Ways to Diversify

The last view that we have is:

  • stocks and options (selling calls)
  • options strike prices
  • option strategies

If I look at my positions, we already have the SPY position on there. I’ll give you a little bit of insight here. We’ll look at the risk profile graph it tells you the movement – the profit or loss on this position.

At this moment we’re down about $70, but here if you look at the axes, this is the strike price of the equity. We’re at 223 – that’s our current price.

As this moves to the upside, we make money. And as this moves to the downside, we lose money, and there is our zero-line. This is the money line on the Left axis. There is positive $1000, positive $500 and down there you start getting into the negative value.

That’s how this line works. You can hedge a position by selling an upside call. Maybe you think this isn’t going to go too much higher. Then I could open up some strike prices (25 strike prices), and I could sell an upside call.

To sell a single, you need about 100 shares. That’s because one contract is based on 100 shares. However, you can see what this contract alone allows me to do. If I look at this individual contract, the white line is our current line today.

The green line is at expiration. If you don’t know too much about options, you might want to review some things on some of the essential videos that I have.

The whole point is that with the time you make this extra $1,39 — everything I reset to zero and made it live price. Now if we hold this position and it doesn’t move we make $84. As I move my mouse, you can see that white line with time as I shift the date gets closer to the green line.

The white line is our current line. And the green line is at expiration. We have a few days remaining in the January positions – about 36 days. If this holds we collect $84 . To do this, we want to make sure we have 100 shares.

Otherwise, we get this massive drop off effect which eventually leads to a substantial harmful or unlimited loss. That is a little bit unlikely with the SPY or the ETF. But we want to buy more shares here.

We’ll buy 80 more, and now we have a full hundred shares. To compensate for this, we can sell a single call option right up there.

That means if it goes down to 220 I lose $650. And if I had it without that single call, I would lose $730. That is simply because of this $84 that I’m compensating and making.

If you notice that at 220 we would be losing $730, but if I add that in at 220 I’d only lose $635. That is because of this $84 that I’m making on this spread. You’re selling additional premium contracts and insurance to help diversify your position in case of the downside move.

The opposite is also happening. It’s too limiting your upside potential. If you get an explosion to the 240, you’ll only make 532. Whereas if you held on to it, you would make $1265.

You would make a lot more if you held on to, but you have that risk. You can diversify it in that way.Do stocks and things like that explode to the upside all the time?

No, not really.

Maybe if you did this 12 months every single month selling these upside calls then perhaps you would get stopped out. And you would lose your hundred shares within one month out of the twelve. That’s depending on how far out you put them.

In either case, imagine doing this after you had a massive run-up. Then you sell at one or two of these contracts. The market probably will pullback with time. That’s another hedging strategy for you.

One of The Other Ways to Hedge

When you have a hedging strategy like this is you could do it based on strike prices. I could do hedging based on different strike prices.

I could sell a vertical over on this side. This would be one of the strike prices. And I could wait a week or two weeks or three weeks and put on another one. Maybe at a different strike price. Let’s say you get filled on this one right here.

I’m filled in there. And then you do another one a week later, and that’s a time-based hedge.

If things go down, you could shift it in the strike prices. Let’s suppose that you did another one at a different strike price or even did it on the call side. And sold another vertical.

All of a sudden you’re creating flexible strategies that allow you to hedge in multiple directions.

I was hedging on the call side and added a vertical on the call side. We got filled, and now I’ve hedged simply by putting on multiple strike prices at different points. I did the puts on the left, and I did the calls on the right.

You could see there are my puts. And then to make it red, there are my calls. You could see that now I’ve created this little hedge for a downside moves for upside moves.

This is based on strike prices. I could if things go down hedge again and add a few more contracts. It depends, but you can move, mix and match at different positions for your contracts.

The Last Strategy

And then finally the last strategy for diversifying and hedging an option strategy is you could put on a different position.

You could put on an Amazon calendar rather than an Iron Condor. If you’re a little confused with options, you’ll probably need to go back and do some more studying regarding options.

Let me go ahead and put this on. I could go to 770 and fill that order. We can see if we’ll get filled. Also, we bump it up to get filled so you could see what’s going on.

I’ve stacked two different positions:

  • I have an Amazon position
  • I have a SPY position

You could see as I turn on and turn off you can see what position has the most weight.

I could continuously add to these positions. For example, I did the SPX position which is similar to the SPY.

However, I’m putting on a slightly different position. I’ll do another Iron Condor to show you different positions. Let me analyze this trade.

This is what I’m doing:

  • I’ll hide the positions
  • Show the simulations

Also, I make it live price on the put side. I want to go down to 2000 because this is multi-thousand stock. That means it doesn’t trade.

You have to move the strike prices in a big way. A current price is 2267, and we need to go much higher here on our strike prices.

We can tighten the put side up a little bit. Maybe a little more on the call side. There we go. Let’s say we do two contracts and fill that order.

Now we hide the simulations and we show the portfolio. You can see we’re creating a weird portfolio graph.

Here we have Amazon, the SPX and the SPY. As I look at these three positions here’s our big picture which I’m diversifying based on positions.

I could take Amazon on and off. And you can see what that does. I could take the SPX on and off, and you can see what that also does.

What’s more, I could do the same thing for the SPY. You could see they’re all affected slightly differently.

Don’t Forget to Apply Different Strategies

Those are the different ways to hedge or manage the risks when it comes to diversifying within your positions.

Remember diversification the simple baseline to diversification is most people think of positions. But you could have diversification based on inverse positions based on time ETF stocks and options mixing those.

Of course, there are more strategies in variations than I shared. Then you can do strike prices and the different types of strategies within options.

For many people and the textbook, definitions are they look at positions. However, that’s not the only way. My advice to you is to look at a few other variations. The goal is to manage and reduce your risk.

Final Word

That’s how you do it. There’re a lot of different ways to hedge and minimize your risk. If you reduce your risk, then that’s the whole point behind diversifying.

When things go against you when things don’t move the way that they should it doesn’t hurt you as bad.

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