This week's edition of Profit Talk covers tools & techniques available to help you create a balanced portfolio tailored to fit your personal trading style and risk tolerance. You'll learn how to easily accomplish this through the use of the Profit Effect exclusive practices "Strategy Match" and "Delta Match".
Welcome to the December 12th 2016 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts.My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
We know that long term successful investing comes from well informed investors applying sound market strategies. Profit Talk was created to help you gain understanding about the investment strategies that work and how to successfully ignore the so called pundits and your own emotions in order to use the modern tools and market key indicators to make investment choices. Here you turn guesswork and chance investing into powerful and informed decision-making.
Over the previous three issues of Profit Talk we’ve covered topics ranging from Implied Volatility Percentile and it’s importance in determining what style of option currently offers the best opportunity for success. We also covered the details of constructing a credit style option strategy called a short Iron Condor. The Iron Condor covered is a style of option strategy that profits when price stays in a range. It holds a neutral directional bias.
In addition, I went over the the details of constructing a debit style strategy I call “Free Trade”. The Free Trade strategy is at the other end of the spectrum when it comes to a directional bias. It is designed to capture a big directional move when you have such an assumption. We also covered the basics of technical analysis and trend.
This Profit Talk edition my intention is to demonstrate how to use this information in the real world of trading. Whether using these strategies to build wealth or create alternative streams of income, success depends on placing as many high probability trades as possible. This resuIts in us holding a portfolio of investments.
It means, when selecting and placing trades or investments we are not operating in a vacuum. Each decision must be weighed against the current holdings in terms of both the style of option position we use and the directional bias of the trade.
Key Components for Trading Success
The importance of both the style of option position we use and the directional bias of the trade, within the proper context, can not be overstated. In fact, when it comes to practicing a successful market investing methodology using options, there is probably no two elements more crucial to success than these. Here at Profit Effect these two key factors are called:
Strategy Match
Delta Match
Strategy Match
There are two considerations when it comes to whether or not the prospective trade has “Strategy Match” or not. First, strategy Match is our main determinate when it comes to Option Strategy selection.This “Strategy Match” is reached by simply aligning the correct option strategy with the current IV Percentile. It is measured as either true or false and is pass or fail for the trade. If we have a match it’s true and we can use the strategy. Otherwise, no match and it’s a fail. Meaning if you want to place a trade in that market pick a matching strategy. I’ve created an easy system to follow when it comes to picking the right strategy for the current IV Percentile of the prospective market. Simply use the “Strategy Selection Graph” and use an option strategy that lines up with the current IV Percentile value of the prospective market. (figure 1)If it does, you’ve overcome the first hurdle for “Strategy Match”.
The second consideration is in how the prospective strategy relates when compared to the current holdings of your portfolio. As mentioned before, when it comes to trading in the financial markets, the probabilities are on the side of the premium seller. These credit style strategies also offer the highest available rewards for non-directional strategies. For these reasons, the temptation is to place as many of these style trades as possible. I for one, openly admit that I would prefer that every one of my trades be a directionally neutral, high probability, credit position. Hey, I mean why not! These positions derive profit as time passes and/or volatility falls, which I know are two things I can count on. But, this desire must be weighed by the facts. The facts as decided by the considerations under our “Strategy Match” rule.
First, is the IV Percentile value for the underlying correct for the type of strategy I want to use? Second, based on the current positions you hold, does your allocation rule allow for another strategy of the type being considered?
“Strategy Match” means:
The underlying IVP is appropriate for the particular strategy
My current portfolio allocation allows for the particular strategy
Delta Match
Another key factor one must take into account when considering a prospective trade is what we call here at Profit Effect “Delta Match”. Delta Match refers to the directional bias of the trade and specifically, how it stacks up with the rest of your current holdings. In order to understand delta match you must first understand what delta means. Delta, measures the rate of change of the option value with respect to changes in the underlying asset's price.
Delta will be a positive number between 0.0 and 1.0 for a long call or a short put. Or, a negative number between 0.0 and −1.0 for a long put or a short call. The Delta defines how much the price of the option will change for every 1 dollar move in the underlying share price.
These numbers are commonly presented as the total number of shares represented by the option contract(s) in terms of the value gained or lost on the position as the underlying price rises and falls. This is because the option will behave like the number of shares indicated by the delta. It is normally referred to in whole numbers as it represents how the “real” number of shares in the underlying would change as the share price changes. For example, a trader who was holding 1 call option that had a delta of positive .25 deltas would see a gain or loss in the value of the position equal to owning 25 shares of the underlying. The trader would say they were long 25 deltas or had 25 positive deltas in that underlying.
On the other hand, if a trader was holding an option position that was -.25 deltas, the value of the position would fluctuate in price, with the directional move of the underlying, just like being short 25 shares. So, putting it simply, everything else being equal, delta tells us our directional risk in the trade and the number of Deltas, either positive (long) or negative (short), defines how many “shares” we have at risk “directionally”. Don’t over complicate it, just think of the number of deltas as the number of shares.
That explains the “delta” side of Delta Match. Now, let’s go over the “match” part of the term. Once again, as traders, we are not operating in a vacuum. In order to create the best chance for success, we need to maintain some diversification among the holdings in our portfolio. It is not wise to overweight our exposure to any single area of the market. In other words, we never want to put all of our eggs in one basket. This means we don’t want to pile on too many deltas or shares, in other words, create too much directional bias in any one underlying or sector of the market. Delta Match is the process we use to determine whether or not the prospective trade is appropriate to add to our portfolio when comes to maintaining proper diversification.
The use of Delta Match in practice means we look at the portfolio as a whole and search for trades that will create or maintain the balance we desire. If the prospective trade does that it has “Delta Match”. Thanks to modern tools included on the top option trading platforms the process of determining the “real” directional bias effect a particular position has on the portfolio has become much easier. But, in order to do this, we must be aware of a crucial fact when it comes to deltas or shares. This fact is, all deltas are not created equal.
Beta Weighting
It’s true, all deltas or shares are not created equal. Some markets move together in varying degrees, which is called positive correlation and other markets move opposite of each other in varying degrees, and this is called negative correlation. The movement or volatility of a market can be measured against another market to compare the historical relationship or degree of correlation the markets experience over time. This is done by using a measure called Beta. Beta is a measure of the volatility or systematic risk of a security or a portfolio against the market as a whole.
Most US investors use the S&P 500 composite as the “whole market” to measure against. This index can be traded just like a stock via the “SPDR ETF” ticker symbol SPY. It contains 500 of the largest companies traded in the US. A stock that has perfect positive correlation has a beta of 1.0.
If the stock has positive correlation but moves in excess of the market, it would have a beta higher than 1.0. For example, if it is 20% more volatile than the market it’s being compared to, it will have a beta of 1.2.
On the other hand, if it generally moves in the opposite direction of the comparison market, it will have negative correlation. The beta number will be displayed as a negative number. Perfect negative correlation is -1.0. Some example markets that carry negative correlation to the market, meaning, historically the price movement is opposite of the market and therefore they have negative beta, are US Treasuries, like ticker symbol TLT and gold, ticker symbol GLD and on the extreme end of negative beta, you have the “Fear Indices” such as VXX or VIX. Long shares of negative beta markets historically rise when the market falls and fall when the broad market rises. Negative beta can also be acquired by selling short a positive beta market.
Here is how beta looks on a trading platform. TLT has a beta of -.582. Historically, when the broad market moves up $1 this moves down 58 cents. When the market moves down $1, TLT moves up 58 cents. (Figure 2) Here’s GLD currently showing very low correlation to the market either way with a reading of -.0159. (Figure 3) On the extreme end of negative beta you have the fear index, the vix, ticker VXX. It has a negative beta of -4.675. Historically, for every $1 up move in the broad market, this asset falls $4.68 and for every down movement in the market, this asset rises $4.68 cents. (Figure 4)
On a side note here, since we’re talking about the VIX, I’m not a financial advisor and don’t give recommendations, but I will say this as a warning to those who don’t want to risk more money than even exists in their account, NEVER, NEVER, NEVER, NEVER, EVER, sell short the VIX. In future Profit Talk issues, we will discuss the numerous ways this wonderful asset class can be used to profit and/or hedge risk. But, in the meantime, I want to be clear, no trade can inflict more financial pain than a short VIX trade during a market panic. So, never short the VIX. Back to the discussion.
The top trading platforms make it simple to employ the use of beta in order to keep track of your overall portfolio bias. This important measure clarifies the directional exposure your portfolio carries. The platform “beta weighting” tool tracks not only the number of deltas or shares being held, but also the beta weighting, or broad market correlation these shares carry. This distinction is referred to as “beta weighted deltas”.
The individual investor must decide for themselves how much correlation with the broad market they prefer. The great thing about options is they give you the opportunity to construct positions with varying degrees of deltas that are positive , negative or neutral. This fact combined with the ability to hold positions that profit from the passage of time and/or directional moves creates the “magic” options bring to the table that is unlike any other asset class.
As an example, if a trader did not want very much exposure to directional risk in the market, so they decided to hold stock in the US broad market and also hold US treasuries as a hedge against downside risk, in essence, creating a beta neutral portfolio. The profit from upside movement in the stock market would be offset by the loss the US treasury position would bring. In addition, any profit the US treasuries realized as the stock market fell would be offset by the loss brought by the US stock market position.
On the other hand, if an option trader created the same “beta neutral” portfolio, but instead of using stock to create the positions, they used short option credit strategies, they would carry little directional exposure in the market yet they could still realize profit from the positions thanks to the nature of short option positions which can profit through the passage of time.
Now imagine creating a diversified portfolio this way. Using the modern tools to determine the real broad market exposure you have and then adjusting that exposure according to your preference. If you prefer more or less exposure or “weighting” in a particular area of the market, you can acquire the exposure by adding or subtracting deltas in that market. Using beta as a tool, you can determine the real risk from broad market movement the exposure will bring. In addition, by using option strategies to create the positions, you have the opportunity to reduce directional risk in any particular area of the market of the your portfolio in general and still create opportunity for profit.
This is the essence of the option seller’s philosophy.The number and type, meaning positive or negative, of beta weighted deltas the option trader chooses to hold comes down to personal preference and trading style. Premium sellers, traders that primarily use short premium strategies to construct their portfolio positions, typically keep their beta weighted portfolio deltas near zero, or slightly negative. Portfolios with this type of beta weighting will generally perform well as the market climbs, falls or moves sideways. Of course, extreme movement in any one direction will create challenges. But, these challenges are usually much more manageable than those that are created by large market moves that go against a portfolio weighted in a particular direction.
Perspective
Now, equipped with this information, searching for and considering prospective trades is seen in a whole light. Whether or not a trade is a good trade or a bad trade goes beyond the analysis of that trade candidate. The decision of whether a prospective trade or investment is good or not depends more on how it correlates with the rest of your portfolio. In the end that is where the real, long term success comes from. It comes down to asset allocation. Take the trade ideas presented in the previous Profit Talk issues. The non-directional Iron Condor trade on GDXJ and the bullish “Free Trade” on ATVI. The circumstances and decision for taking the individual trades themselves may be perfectly sound, but whether or not they are “good” trades for someone to take depends on their current portfolio plan and how the prospective trades stacks up in terms of strategy match and delta match.
I’ll finish up this discussion with an example. Here’s a small portfolio of holdings that contain bullish bearish and neutral positions. The non beta weighted deltas are shown in this column for each position with the total portfolio net deltas displayed in the bottom row. (Figure 5) The non-weighted number is currently around 1100 positive deltas. So, with the bullish, bearish and neutral positions combined it’s like being long about 1100 shares. However, when measured against the broad market, when “beta weighted”, the directional exposure is more like owning 100 shares. (Figure 6) This is because some of those 1100 positive deltas have negative correlation, negative beta, to the broad market. When the market goes up, they go down and vice versa, when the market goes down, they go up. This way, if a trader chooses, they can create a portfolio that has more or less risk in either market direction, but carries the risk using short option strategies in either case. This way profit is derived through volatility collapse and time passing “theta decay” and not necessarily dependent on market direction.
Market Outlook
Now that you have a handful of Profit Talk issues under your belt and have been exposed to a sprinkling of the Profit Effect trading philosophy. Including, the subject of technical analysis as covered in the last issue. It’s time to introduce a new, regular weekly segment that includes a market outlook for the coming week. As your technical analysis knowledge builds, we will add more layers of complexity to the market outlook and analysis. This broad market study will provide context for the educational trade ideas presented and avenues for locating additional investment opportunities.
Looking back to the technical analysis discussion, the first question is always what the big picture trend direction is. Looking at the broad market via the exchange traded fund, ticker SPY, today we are again making all time highs in the market. The trend is clearly up on all the major time frames including the big picture time frame. Remember, big picture trend direction determines the trade direction. This means, if looking to take a trade in the broad market itself, or in a stock that is highly correlated with the broad market, you would look to enter bullish trades to join the trend. In addition, we use contrarian or “counter trend” moves in the market for entry opportunities. Simply put, we’re looking for near term price weakness to bring prices down to a demand zone where entry can occur.
Study of the daily chart for SPY shows horizontal demand where price broke through the previous high. This qualifies as a “horizontal” demand zone. (Figure 7) In addition, a moving average demand zone exists in the area of the 20 period moving average as denoted by these grey dashes around on either side of the average. (Figure 8) The area from the average to the dash above the average is the demand zone. The horizontal demand zone and the moving average demand zone correlate nicely. If entry in the broad market or a correlating market is desired, a pull back to this demand area provides the best opportunity for success.
If you throw a quick, somewhat sloppy trend line on the chart, you can see a possible excuse for some profit taking as prices bump up against this trend line. (Figure 9) This may provide the weakness needed to provide a bullish entry. When the market is trading at all time highs, there is no opportunity for bearish entries in that market. As difficult as buying a market is when trading at its highs, the fact is this market is in a clearly defined uptrend and buying pullbacks into demand offers the best odds for success.
Main Takeaways
The main takeaways this edition of Profit Talk are First, use strategy match to guide strategy selection. Remember, never use a strategy when the IV Percentile is not appropriate for the particular strategy and never overweight your portfolio with too many positions using the exact same strategy
Second, Delta numbers and share numbers mean the same thing and define how much directional risk the position or portfolio holds
Third, make sure you understand and manage systemic risk, meaning broad market “melt down” risk. You can do this using beta to see how various markets correlate to one another. Never create too much exposure in anyone area of the market.
A Look Ahead
As an exercise this week, use the information presented in this edition of Profit Talk regarding beta weighted delta and strategy match to survey your current portfolio as well as your personal preferences when it comes to how you’d like your portfolio positioned going forward. Then incorporate the market outlook and chart analysis conclusions to consider prospective trade candidates. I’m optimistic that armed with these new skills, you’ll discover new ways to look at investing and profiting in the markets.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts.My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
We know that long term successful investing comes from well informed investors applying sound market strategies. Profit Talk was created to help you gain understanding about the investment strategies that work and how to successfully ignore the so called pundits and your own emotions in order to use the modern tools and market key indicators to make investment choices. Here you turn guesswork and chance investing into powerful and informed decision-making.
Over the previous three issues of Profit Talk we’ve covered topics ranging from Implied Volatility Percentile and it’s importance in determining what style of option currently offers the best opportunity for success. We also covered the details of constructing a credit style option strategy called a short Iron Condor. The Iron Condor covered is a style of option strategy that profits when price stays in a range. It holds a neutral directional bias.
In addition, I went over the the details of constructing a debit style strategy I call “Free Trade”. The Free Trade strategy is at the other end of the spectrum when it comes to a directional bias. It is designed to capture a big directional move when you have such an assumption. We also covered the basics of technical analysis and trend.
This Profit Talk edition my intention is to demonstrate how to use this information in the real world of trading. Whether using these strategies to build wealth or create alternative streams of income, success depends on placing as many high probability trades as possible. This resuIts in us holding a portfolio of investments.
It means, when selecting and placing trades or investments we are not operating in a vacuum. Each decision must be weighed against the current holdings in terms of both the style of option position we use and the directional bias of the trade.
Key Components for Trading Success
The importance of both the style of option position we use and the directional bias of the trade, within the proper context, can not be overstated. In fact, when it comes to practicing a successful market investing methodology using options, there is probably no two elements more crucial to success than these. Here at Profit Effect these two key factors are called:
Strategy Match
Delta Match
Strategy Match
There are two considerations when it comes to whether or not the prospective trade has “Strategy Match” or not. First, strategy Match is our main determinate when it comes to Option Strategy selection.This “Strategy Match” is reached by simply aligning the correct option strategy with the current IV Percentile. It is measured as either true or false and is pass or fail for the trade. If we have a match it’s true and we can use the strategy. Otherwise, no match and it’s a fail. Meaning if you want to place a trade in that market pick a matching strategy. I’ve created an easy system to follow when it comes to picking the right strategy for the current IV Percentile of the prospective market. Simply use the “Strategy Selection Graph” and use an option strategy that lines up with the current IV Percentile value of the prospective market. (figure 1)If it does, you’ve overcome the first hurdle for “Strategy Match”.
The second consideration is in how the prospective strategy relates when compared to the current holdings of your portfolio. As mentioned before, when it comes to trading in the financial markets, the probabilities are on the side of the premium seller. These credit style strategies also offer the highest available rewards for non-directional strategies. For these reasons, the temptation is to place as many of these style trades as possible. I for one, openly admit that I would prefer that every one of my trades be a directionally neutral, high probability, credit position. Hey, I mean why not! These positions derive profit as time passes and/or volatility falls, which I know are two things I can count on. But, this desire must be weighed by the facts. The facts as decided by the considerations under our “Strategy Match” rule.
First, is the IV Percentile value for the underlying correct for the type of strategy I want to use? Second, based on the current positions you hold, does your allocation rule allow for another strategy of the type being considered?
“Strategy Match” means:
The underlying IVP is appropriate for the particular strategy
My current portfolio allocation allows for the particular strategy
Delta Match
Another key factor one must take into account when considering a prospective trade is what we call here at Profit Effect “Delta Match”. Delta Match refers to the directional bias of the trade and specifically, how it stacks up with the rest of your current holdings. In order to understand delta match you must first understand what delta means. Delta, measures the rate of change of the option value with respect to changes in the underlying asset's price.
Delta will be a positive number between 0.0 and 1.0 for a long call or a short put. Or, a negative number between 0.0 and −1.0 for a long put or a short call. The Delta defines how much the price of the option will change for every 1 dollar move in the underlying share price.
These numbers are commonly presented as the total number of shares represented by the option contract(s) in terms of the value gained or lost on the position as the underlying price rises and falls. This is because the option will behave like the number of shares indicated by the delta. It is normally referred to in whole numbers as it represents how the “real” number of shares in the underlying would change as the share price changes. For example, a trader who was holding 1 call option that had a delta of positive .25 deltas would see a gain or loss in the value of the position equal to owning 25 shares of the underlying. The trader would say they were long 25 deltas or had 25 positive deltas in that underlying.
On the other hand, if a trader was holding an option position that was -.25 deltas, the value of the position would fluctuate in price, with the directional move of the underlying, just like being short 25 shares. So, putting it simply, everything else being equal, delta tells us our directional risk in the trade and the number of Deltas, either positive (long) or negative (short), defines how many “shares” we have at risk “directionally”. Don’t over complicate it, just think of the number of deltas as the number of shares.
That explains the “delta” side of Delta Match. Now, let’s go over the “match” part of the term. Once again, as traders, we are not operating in a vacuum. In order to create the best chance for success, we need to maintain some diversification among the holdings in our portfolio. It is not wise to overweight our exposure to any single area of the market. In other words, we never want to put all of our eggs in one basket. This means we don’t want to pile on too many deltas or shares, in other words, create too much directional bias in any one underlying or sector of the market. Delta Match is the process we use to determine whether or not the prospective trade is appropriate to add to our portfolio when comes to maintaining proper diversification.
The use of Delta Match in practice means we look at the portfolio as a whole and search for trades that will create or maintain the balance we desire. If the prospective trade does that it has “Delta Match”. Thanks to modern tools included on the top option trading platforms the process of determining the “real” directional bias effect a particular position has on the portfolio has become much easier. But, in order to do this, we must be aware of a crucial fact when it comes to deltas or shares. This fact is, all deltas are not created equal.
Beta Weighting
It’s true, all deltas or shares are not created equal. Some markets move together in varying degrees, which is called positive correlation and other markets move opposite of each other in varying degrees, and this is called negative correlation. The movement or volatility of a market can be measured against another market to compare the historical relationship or degree of correlation the markets experience over time. This is done by using a measure called Beta. Beta is a measure of the volatility or systematic risk of a security or a portfolio against the market as a whole.
Most US investors use the S&P 500 composite as the “whole market” to measure against. This index can be traded just like a stock via the “SPDR ETF” ticker symbol SPY. It contains 500 of the largest companies traded in the US. A stock that has perfect positive correlation has a beta of 1.0.
If the stock has positive correlation but moves in excess of the market, it would have a beta higher than 1.0. For example, if it is 20% more volatile than the market it’s being compared to, it will have a beta of 1.2.
On the other hand, if it generally moves in the opposite direction of the comparison market, it will have negative correlation. The beta number will be displayed as a negative number. Perfect negative correlation is -1.0. Some example markets that carry negative correlation to the market, meaning, historically the price movement is opposite of the market and therefore they have negative beta, are US Treasuries, like ticker symbol TLT and gold, ticker symbol GLD and on the extreme end of negative beta, you have the “Fear Indices” such as VXX or VIX. Long shares of negative beta markets historically rise when the market falls and fall when the broad market rises. Negative beta can also be acquired by selling short a positive beta market.
Here is how beta looks on a trading platform. TLT has a beta of -.582. Historically, when the broad market moves up $1 this moves down 58 cents. When the market moves down $1, TLT moves up 58 cents. (Figure 2) Here’s GLD currently showing very low correlation to the market either way with a reading of -.0159. (Figure 3) On the extreme end of negative beta you have the fear index, the vix, ticker VXX. It has a negative beta of -4.675. Historically, for every $1 up move in the broad market, this asset falls $4.68 and for every down movement in the market, this asset rises $4.68 cents. (Figure 4)
On a side note here, since we’re talking about the VIX, I’m not a financial advisor and don’t give recommendations, but I will say this as a warning to those who don’t want to risk more money than even exists in their account, NEVER, NEVER, NEVER, NEVER, EVER, sell short the VIX. In future Profit Talk issues, we will discuss the numerous ways this wonderful asset class can be used to profit and/or hedge risk. But, in the meantime, I want to be clear, no trade can inflict more financial pain than a short VIX trade during a market panic. So, never short the VIX. Back to the discussion.
The top trading platforms make it simple to employ the use of beta in order to keep track of your overall portfolio bias. This important measure clarifies the directional exposure your portfolio carries. The platform “beta weighting” tool tracks not only the number of deltas or shares being held, but also the beta weighting, or broad market correlation these shares carry. This distinction is referred to as “beta weighted deltas”.
The individual investor must decide for themselves how much correlation with the broad market they prefer. The great thing about options is they give you the opportunity to construct positions with varying degrees of deltas that are positive , negative or neutral. This fact combined with the ability to hold positions that profit from the passage of time and/or directional moves creates the “magic” options bring to the table that is unlike any other asset class.
As an example, if a trader did not want very much exposure to directional risk in the market, so they decided to hold stock in the US broad market and also hold US treasuries as a hedge against downside risk, in essence, creating a beta neutral portfolio. The profit from upside movement in the stock market would be offset by the loss the US treasury position would bring. In addition, any profit the US treasuries realized as the stock market fell would be offset by the loss brought by the US stock market position.
On the other hand, if an option trader created the same “beta neutral” portfolio, but instead of using stock to create the positions, they used short option credit strategies, they would carry little directional exposure in the market yet they could still realize profit from the positions thanks to the nature of short option positions which can profit through the passage of time.
Now imagine creating a diversified portfolio this way. Using the modern tools to determine the real broad market exposure you have and then adjusting that exposure according to your preference. If you prefer more or less exposure or “weighting” in a particular area of the market, you can acquire the exposure by adding or subtracting deltas in that market. Using beta as a tool, you can determine the real risk from broad market movement the exposure will bring. In addition, by using option strategies to create the positions, you have the opportunity to reduce directional risk in any particular area of the market of the your portfolio in general and still create opportunity for profit.
This is the essence of the option seller’s philosophy.The number and type, meaning positive or negative, of beta weighted deltas the option trader chooses to hold comes down to personal preference and trading style. Premium sellers, traders that primarily use short premium strategies to construct their portfolio positions, typically keep their beta weighted portfolio deltas near zero, or slightly negative. Portfolios with this type of beta weighting will generally perform well as the market climbs, falls or moves sideways. Of course, extreme movement in any one direction will create challenges. But, these challenges are usually much more manageable than those that are created by large market moves that go against a portfolio weighted in a particular direction.
Perspective
Now, equipped with this information, searching for and considering prospective trades is seen in a whole light. Whether or not a trade is a good trade or a bad trade goes beyond the analysis of that trade candidate. The decision of whether a prospective trade or investment is good or not depends more on how it correlates with the rest of your portfolio. In the end that is where the real, long term success comes from. It comes down to asset allocation. Take the trade ideas presented in the previous Profit Talk issues. The non-directional Iron Condor trade on GDXJ and the bullish “Free Trade” on ATVI. The circumstances and decision for taking the individual trades themselves may be perfectly sound, but whether or not they are “good” trades for someone to take depends on their current portfolio plan and how the prospective trades stacks up in terms of strategy match and delta match.
I’ll finish up this discussion with an example. Here’s a small portfolio of holdings that contain bullish bearish and neutral positions. The non beta weighted deltas are shown in this column for each position with the total portfolio net deltas displayed in the bottom row. (Figure 5) The non-weighted number is currently around 1100 positive deltas. So, with the bullish, bearish and neutral positions combined it’s like being long about 1100 shares. However, when measured against the broad market, when “beta weighted”, the directional exposure is more like owning 100 shares. (Figure 6) This is because some of those 1100 positive deltas have negative correlation, negative beta, to the broad market. When the market goes up, they go down and vice versa, when the market goes down, they go up. This way, if a trader chooses, they can create a portfolio that has more or less risk in either market direction, but carries the risk using short option strategies in either case. This way profit is derived through volatility collapse and time passing “theta decay” and not necessarily dependent on market direction.
Market Outlook
Now that you have a handful of Profit Talk issues under your belt and have been exposed to a sprinkling of the Profit Effect trading philosophy. Including, the subject of technical analysis as covered in the last issue. It’s time to introduce a new, regular weekly segment that includes a market outlook for the coming week. As your technical analysis knowledge builds, we will add more layers of complexity to the market outlook and analysis. This broad market study will provide context for the educational trade ideas presented and avenues for locating additional investment opportunities.
Looking back to the technical analysis discussion, the first question is always what the big picture trend direction is. Looking at the broad market via the exchange traded fund, ticker SPY, today we are again making all time highs in the market. The trend is clearly up on all the major time frames including the big picture time frame. Remember, big picture trend direction determines the trade direction. This means, if looking to take a trade in the broad market itself, or in a stock that is highly correlated with the broad market, you would look to enter bullish trades to join the trend. In addition, we use contrarian or “counter trend” moves in the market for entry opportunities. Simply put, we’re looking for near term price weakness to bring prices down to a demand zone where entry can occur.
Study of the daily chart for SPY shows horizontal demand where price broke through the previous high. This qualifies as a “horizontal” demand zone. (Figure 7) In addition, a moving average demand zone exists in the area of the 20 period moving average as denoted by these grey dashes around on either side of the average. (Figure 8) The area from the average to the dash above the average is the demand zone. The horizontal demand zone and the moving average demand zone correlate nicely. If entry in the broad market or a correlating market is desired, a pull back to this demand area provides the best opportunity for success.
If you throw a quick, somewhat sloppy trend line on the chart, you can see a possible excuse for some profit taking as prices bump up against this trend line. (Figure 9) This may provide the weakness needed to provide a bullish entry. When the market is trading at all time highs, there is no opportunity for bearish entries in that market. As difficult as buying a market is when trading at its highs, the fact is this market is in a clearly defined uptrend and buying pullbacks into demand offers the best odds for success.
Main Takeaways
The main takeaways this edition of Profit Talk are First, use strategy match to guide strategy selection. Remember, never use a strategy when the IV Percentile is not appropriate for the particular strategy and never overweight your portfolio with too many positions using the exact same strategy
Second, Delta numbers and share numbers mean the same thing and define how much directional risk the position or portfolio holds
Third, make sure you understand and manage systemic risk, meaning broad market “melt down” risk. You can do this using beta to see how various markets correlate to one another. Never create too much exposure in anyone area of the market.
A Look Ahead
As an exercise this week, use the information presented in this edition of Profit Talk regarding beta weighted delta and strategy match to survey your current portfolio as well as your personal preferences when it comes to how you’d like your portfolio positioned going forward. Then incorporate the market outlook and chart analysis conclusions to consider prospective trade candidates. I’m optimistic that armed with these new skills, you’ll discover new ways to look at investing and profiting in the markets.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
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