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
This edition of Profit Talk we’ll cover some tools & techniques that can be used to help create and maintain a portfolio that is suited to fit both your personal directional assumptions for the market and personal risk tolerances. You’ll learn ways to create a portfolio that can be positioned for opportunity or defense depending on market circumstances and or personal preferences when investing.
As we’ve covered our primary trading goal at Profit Effect is to place as many non-correlated, high probability trades as possible while continually taking profits and managing risk.
One of the key essentials required in achieving this is in our ability to monitor the price correlation of the markets we trade. We strive to create as many trades that are independent of each other as we can. This important goal is the basis for one of the main components of our trading philosophy at Profit Effect which is “Delta Match”
We consider the trade a “match” when it’s correlation to what we currently have in the Portfolio is appropriate and fits the directional bias we are attempting to carry in our portfolio. Our attempt here is to create what is commonly referred to as a “diversified portfolio”.
The unprecedented current economic situation of having the broad financial markets at or near all time highs while interest rates sit near historic lows, has made the process of finding true non-correlated assets extremely difficult. The fact is that when sell offs occur in today's markets, all traditional assets go down.
Even what has traditionally been the safe haven asset class, US Treasury Bonds, will not offer much protection at these prices.
There is not enough room to move before you’re at negative interest rates. If a negative interest rate situation occurs those wishing to hold cash or an asset backed by the US government will have pay out money rather than receive a return.
This phenomenon did occur for a brief time during the 2008 crash, as the panic stricken global markets poured into US Treasury Bonds and/or accounts backed by Treasury bonds…”Money Market” accounts. During this time the interest rates went negative. You had to pay to hold cash.
However the Fed Funds rate was sitting at 2% when the 2008 market meltdown occurred. The funds rate had been trending lower from 6% down to 2% because of market weakness prior to the sell off occurred the first week of October when the DOW dropped from the 10,800 range to under 7,800. Shedding almost 30% of it’s value over a handful of days. For a period of time during the height of the panic the interest rates went negative in the US.
At the time of this writing we currently have a 1% fed funds rate. This leaves an even smaller cushion than the 2% rate in place prior to the last significant selloff. So, there is not much more room to move before going negative.
In addition, commodities or foreign markets are no longer a safe haven. It is now a global economy and the major world markets, commodities and most assets become highly correlated when significant sell-offs occur.
This simply means that many of the “traditional” ways to hedge market risk, such as owning emerging markets, precious metals like gold or silver and treasury bonds should be considered by the investor to offer some limited non-correlation in a stock portfolio. But, should not be relied upon as the sole means to hedge in today’s markets.
Fortunately, we have tools and techniques available to us which can greatly enhance our ability to create a portfolio of positions that do offer an adequate amount of true, beneficial diversification.
Monitoring tools such as Delta and Beta Weighting
Alos, modern financial products such as the numerous ETF’s we can trade and the the ability to trade and use market volatility products
In addition, the ability to be long and short markets gives us access to a variety of both profit opportunities and risk defensive techniques.
Some of the topics have been covered previously and will be review.
A 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. Simply stated, the delta amount of a position is like the share amount of a position.
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.
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. Also, US dollar which can be traded through the ticker symbol UUP.
And, on the extreme end of negative beta, you have the “Fear Indices” such as represented by the ticker symbols 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.
The benefit comes when we can put these tools to use to better understand our exposure. You must determine for yourself, the amount of directional exposure you want for your portfolio and consistently monitor and adjust the beta weighted deltas accordingly.
The ETF Advantage
Some additional tools available to us for creating diversification, and maintaining proper deltas in our portfolio come in the form of modern day financial products such as ETFs. Exchange Traded Funds (ETF’s) are marketable securities that come in a variety of forms. They trade just like stocks and cover a myriad of markets such as indexes, market sectors, commodities and currency markets.
Thanks to the availability and popularity of ETFs, a trader could choose to never invest or trade an individual company name again. In fact, many very successful professional traders use just a few non-correlated markets to trade via ETFs and make a great living doing so. Many use just one market, the S&P 500 Index, which is considered the best representative of the largest 500 US company stocks.
The highest volume ETF in the world which represents ownership in these top 500 stocks is ticker symbol SPY. Remember, liquidity is a trader’s best friend. The high volume of participants results in options that trade on this diversified product with a bid/ask spread of 1 penny most of the time. This means the difference in prices between participants offering the product for sale and offering to buy are only separated by 1 penny.
In addition to allowing us to diversify among the 500 largest companies, we can use these wonderful products to represent a seemingly endless variety of asset classes, including precious metals, foreign stock markets or regions, currencies, interest rate products and even Volatility itself.
Utilizing Volatility ETFs
Due to the advent ETFs and the growing popularity of Options trading, we have found that Volatility itself is considered a new asset class. Volatility as an asset class can be used both for speculation and/or portfolio hedging, and has led to the introduction of numerous new products which can benefit today’s investor
The most liquid and therefore most useful products include:
VIX options - These are options that trade on the index denoted by ticker symbol VIX.
This index often referred to as the “fear index” represents a measure of the market’s expectation of stock market volatility over the next 30 day period. The options use the index as the underlying in regards to settlement so they settle in cash not stock. They also have European style expiration which means you can’t exercise them until the day of expiration and there is no real limit on how high or low price can go until day of exercise. The expiration date is different than on most equity options.
The VIX options expiration is usually the Wednesday before regular Friday monthly expiration, This is because it’s settlement price is based on the SPX index which settles Wednesday.
Another volatility product which can be traded and has adequate volume is an Exchange Traded Note (ETN), ticker symbol VXX. The ETN product from our point of view trades just like an ETF or stock. The options on VXX trade just like the majority of equity options we trade, which are “American Style” and have the usual rules around expiration. They also settle to shares in the underlying just like most of the options we trade.
Neither of these products do a perfect job of tracking volatility because of the problems associated with tracking a futures contract, and proper settlement, etc. Also, there is “drag” associated with the longer-term ownership of these products due to “carry costs” associated with roll-over and decay on futures contracts.
Though, they still offer us benefit as a direct hedge during market sell offs because Volatility spikes when the market turns and a real panic sends volatility soaring. This provides a nice hedge to our long Delta positions and short put exposure.
In regards to which one to use, they both have their pros and cons. VXX has the same expiration and settlement rules as the other options so is easier to use for most people. VIX seems to offer a more pure play on volatility with less drag, however its settlement procedure causes pricing anomalies in the Greeks and the pricing of the product in relation to the futures contract it tracks. This phenomenon in the VIX product is reconciled upon expiration and weekly options are available, so we’re able to use the current expiring “weekly” options as a proxy to figure correct pricing and Greeks as a “work around” for analysis.
In the end, when volatility is near the low end of it’s range, I’ll simply use the most advantageous product and strategy at the time, to allocate some long Deltas to the asset class called Volatility.
Trading Both Sides
Another concept we can use to add diversification to our portfolio and limit directional risk is our ability to trade both sides of the market. This means we are able to carry long and short positions in our portfolio, which adds greatly to our ability to truly diversify our holdings.
We can choose whether our portfolio has a long or short bias and to what degree.
Or, we can employ a neutral stance, when it comes to market direction. We do this by being long, short or neutral “beta weighted deltas” which are beta weighted to the S&P 500 Index as covered previously.
In the end, a nice balance between some long, short and non-directional positions which create a near neutral “beta weighted deltas” portfolio works for the average investor. Though, I will say that many professionals who trade with a similar methodology as taught here, which is based mainly in premium selling strategies, tend to structure their portfolio with some short deltas
This is because during market sell-offs premium expands drastically. As premium sellers, our goal is to be net short volatility and in extended uptrends, which tend to precede selloffs, it’s in our strategy to be short premium (volatility) by selling puts. That’s because short Puts carry long deltas, we lean long in uptrends. This works great until a correction or decent sell off occurs.
Remember, with options, we can be short volatility while long deltas. The portfolio that is net short volatility and carries long deltas will feel more pain in the short term as the losses from the long directional bias created by having long Deltas is compounded when the short premium positions get hurt from volatility expansion. It is for this reason that many premium sellers prefer to keep the portfolio deltas slightly negative. When doing so, the negative brought by volatility expansion will be offset by the positive directional gain derived from a short delta portfolio in a falling market.
The point here is when it comes to market direction, we can’t predict the future and no matter what our personal opinions may be, we need to be all business when we invest our money for profit. We must force ourselves to be as objective as possible which can be done in a real sense by keeping our exposure to unpredictable, systemic (broad market) risk as neutral as possible.
This means, while we may make very directional “bets” with some of our individual positions within the portfolio,it’s generally best to keep the overall portfolio delta as measured against the broad market, near flat or just slightly long/short depending on our personality. During sell offs, the wise investor who is diligent in managing this important portfolio measure is rewarded for the effort.
The main takeaways this week are:
First, Beta weight your deltas to monitor the real systemic risk your portfolio holds. Use this wonder tool to help preserve a non-bias view of the risk your portfolio contains.
Second, volatility products and other types of ETFs can be used to help maintain real diversification
Third, placing positions that carry negative deltas help with diversification as well. Strategically use short selling to round out your portfolio
This past week on Tuesday the 21st we saw some weakness in the US markets. It was reported as being the biggest 1-day down move in more than 5 months. Personally, I was hoping for some follow through, but it has not happened.
The short term uptrend has been broken, but the longer term trend remains intact. I would be interested in a placing a buy trade in this area where price broke out in early February. This is a demand zone that lines up well with the long term average. Keep an eye out this week and see if we can’t get price to fall into this zone for a long trade entry. (Figure 1)
The high impact reports due out this week include:
Tuesday 3/28 - The Consumer Confidence report being released at 10:00 am eastern
Wednesday 3/29 - Crude Oil Inventory report released at 10:30 am
Thursday 3/30 - Final GDP and Unemployment claims will be released at 8:30 am eastern
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 firstname.lastname@example.org.
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.