Options Basics & Fundamentals

How Option Traders Can Diversify & Minimize Their Risk Ep 223

February 14th, 2019

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Today we're going to take a look at how you can diversify your trades and investments if you're an option trader.

If you're trading stocks or investing in the stock market, it's easier to diversify because you get a few telecom companies a few oil companies and now you're diversified.

In simple words, you could buy an ETF or a fund, and now you're pretty much diversified. But when it comes to trading options, it's a little bit different.

That's where we're going to go over in this post, so stay with us.

Most Common Scenario If You Are an Option Trader

Let's take a look at figuring out how you can diversify if you're an option trader.

An average investor or an ordinary stock trader typically diversify things in different areas. It might be something like this: they have some in an oil company, tech, retail, food-related and utilities. That's an overall picture of how people diversify in general with a stock holding.

If you have an overall portfolio this is the case: You might only have some overall in stocks, in real estate, or some other investments. It could be gold, gold coins, and other things.

Any other case, which you're really looking at usually, you have a distribution of funds. And that's the way ordinary people do it.

But when it comes to options, it's a little bit more difficult.

How To Properly Look at Option Diversification

You have three ways to diversify when it comes to options and split the risk.

  1. The way based on vehicle
  2. The way based on a timeframe
  3. The way based on the volatilities

If you apply all of this, you will get a pretty good mix between these three different mediums.

1. Way Based on Vehicle

You could diversify based on the car or vehicle that you're trading.

You might have a Netflix, Apple, ExxonMobil, AT&T. Or it could be eBay and Under Armour or something else. The critical thing is that you're looking at the difference of your vehicle.

2. Way Based on a Timeframe

The other way you could do it is looking at the time frame that you're trading on.

With time you have some options that are you're doing 30-day trades. That way you can split your risk and diversify. This specific trade means - more money every month trades.

Or you could do 60-90 day trades, or you might even do 350 plus days (more long term investor type trades). Which means this might be longer term investing.

By diversifying based on your time of the holdings (and when you're putting on the trade), that can split things up and reduce your risk.

3. Way Based on the Volatilities

That is the third way to do that, and it's based on a strategy that you use.

For example, you might be doing some trades that are iron condors and some traits that are Butterflies. These are all negative Vega trades.

Now, to combat that (the volatility risk) we need some positive Vega trades.

Positive Vega trades would be something like:

  •  Calendar
  •  Diagonal
  •  Double diagonal

But, what's important is that this would combat the iron condors or the butterflies.

If you effectively combine the first two, it is going to give you some diversification. But, the real thing is when there is this one as well.

The third is gives you the opportunity to create negative Vega strategies and positive Vega strategies. After that, all of a sudden, you have harmony between these three different mediums.

What it gives you all of this is an excellent variation to a portfolio when you're trading options.

A Quick Example of Creating Something on a Trade

Let's say you went ahead with Netflix and you did an Iron Condor and you made a forty-day trade. Then on Exxon Mobil, you did a calendar, but you made a 360-day trade. At this moment, you can see how this starts to diversify you quite a bit already. And then let's say you do SPY and maybe you do a Butterfly and something around 180 days.

You start to see that you can mix and match short Vega and some shorter term, medium term, and longer term trades and something that's already ETF and two stocks.

You can see how that diversification plays an excellent role within your option trades. And it works a little bit different than a portfolio because you have more elements in there. You have a time element, a volatility element.

Conclusion

This is what I would look at if you're trying to evaluate your option for a portfolio. Take a look at the vehicle you're trading, look at diversification of that; 3 to 5 vehicles is more than fine.

Look at the time horizon and then of course look at the volatility. Some could be shorter-term strategies and others could be longer-term volatility strategies - like a double diagonal or a calendar spread.

I'm Sasha, an educational entrepreneur and a stock trader. In addition to running my own online businesses, I also enjoy trading stocks and helping the individual investor understand the stock market. Let me share with you some techniques & concepts that I used over the last 10+ years to give you that edge in the market. Learn More

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