Nothing is worse than taking a prominent position in a stock, then waking up the next morning to find it down 20%.
Trust me…it sucks.
I learned the hard way to balance where to push my edge and when to back off.
Even with all the trial and error I went through, the techniques I learned were remarkably simple. In fact, you can put them into practice today.
No one can prevent their portfolio from taking swings back and forth. That’s just part of trading the market. However, you can reduce the magnitude of thee movements with proper portfolio analysis.
It all comes down to one word – correlation.
But, I want to teach you how to look at it from a completely different angle, one that doesn’t require you to own half the S&P 500.
Before I get into the meat of the matter, I want to go over a key statistical concept – correlation. This measures the likelihood of two things moving in tandem. For example, the S&P 500 and the Nasdaq 100 have a high correlation since they both tend to rise and fall together. On the other hand, the S&P 500 and bonds are negatively correlated since they move in opposite directions.
Correlation works on a scale of -1 to 1, with -1 meaning they move in the exact opposite direction, 1 meaning they move in the same direction, and 0 meaning they trade completely independently.
Financial advisors talk about correlated stocks all the time. This is one of the few places they get it right. When you trade stocks like Google and Facebook, they tend to move together more than Google and Exxon Mobile.
However, I want to take this a step further and really give you something to think about.
Diversify your options strategy based on implied volatility
Sometimes I like to buy call and put options on a stock. Other times I prefer to sell credit spreads. How do I decide when to do this?
I look at the stock’s implied volatility. Implied volatility is the options market’s prediction about how much the stock should move in percentage terms over 365 days. Each equity has its own implied volatility.
During periods of high implied volatility, option prices cost more. When implied volatility drops, so do option prices. So, you want to be a buyer of options when implied volatility is low and a seller when it’s high.
There are two ways to figure out whether implied volatility is high or low. First is called IV Rank. This method looks at the entire range of IV over the last year and tells you what percentile the current IV lands. The other way is called IV percentile. That method takes each day’s IV, then tells you where the current IV lands when you look at all the values from each day.
If that confuses you, I would stick with IV Rank, it’s my favorite choice.
I want to be an option seller when IV rank is over 30 and a buyer when it is under 20.
Now, you can diversify your trades by having some that sell premium paired with others that buy premium. That way, you’re expanding the types of options strategies you have based on implied volatility.
Believe it or not, this will actually help reduce the overall volatility of your portfolio!
Review your delta
Delta is a fancy Greek symbol that traders use to talk about how much an option moves for every +$1 change in the underlying. Call options will have positive deltas all the way up to 1 and puts will have negative options all the way down to -1. Options that are at-the-money (where strikes match the current stock price) will come in at 0.5 and -0.5 for calls and puts, respectively.
How delta changes with a stock’s price at expiration
When you look at your entire portfolio, you can see the overall delta of your current positions. This tells you how much exposure you have to a bullish or bearish bias.
Think of it like the number of shares you control. A delta of 100 means you control 100 shares of stock.
Ready for the secret? Weight your stocks to the S&P 500!
Most platforms will allow you to do what’s known as ‘Beta’ weighting. This looks at the correlation between the stock and the S&P 500 and adjusts the delta accordingly.
Here’s why I do this. If I own call options on TLT, which is a bond ETF, it makes no sense to look at that as a positive delta in a portfolio of stocks since it trades typically in the opposite direction. But, when I Beta weight it to the S&P 500, now it will show a negative delta.
This gives you a whole new perspective when you look at the balance of your portfolio.
Practice a balanced portfolio
Learning how to create a balanced portfolio doesn’t come easy. I leaned on my journal to help me understand where my opportunities were.
I can’t overstate the value of a trader’s journal. It’s by far the biggest reason for my success that let me turn $38,000 into over $2,000,000.
You can learn about how I did this in my upcoming webinar. It’s chock-full of tips and tricks that can help you become a better trader.