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 a technique I love to use that I refer to as “Trading Delta for Cash”. The process of trading delta for cash involves more of a shift in thinking than any real technique. The process to implement the trade is extremely simple. The challenges for most, lie in their inability to change their false beliefs about how money is made trading or investing. Money is always made with strategy.
As I’ve said previously, long term success at anything comes from consistently applying specialized knowledge backed by a plan and expressing that plan in continuous action. The ability to do this requires a person to change how they think about certain things. Here I want to forever change the way you view stocks or any other investment and the way in which you can profit from these assets.
As discussed in many previous editions of Profit Talk, the delta value of an option position determines the amount of directional exposure the position has to the underlying stock’s price movement. I often say think of deltas like you think of shares in a stock. If you have 100 positive delta in a market it’s like having 100 long shares in that market. If holding 100 negative delta, it’s like being short 100 shares in that market.
The fact is that the use of delta to value directional exposure does not just apply to stocks and options. Delta can be used to measure directional risk across all asset classes. This means stocks, ETFs and ETNs, Options and Futures contracts and Forex. All these products have a delta value and should be thought of by a serious trader or investor in this way. Be agnostic in terms of the product being used. In this context, agnostic means not preferring a particular device or system.
For example, I often mention the ETF which represents the S&P 500 index which is the broad US market. The ETF ticker is SPY. As a trader I can acquire delta in this index in several different ways. Let’s say I wanted to be long or short 500 deltas in this the market. I can buy 500 shares of stock via the ETF SPY for positive 500 deltas or short 500 shares of the stock for 500 negative delta.
Or, If want to use options to create a 500 delta position that is either positive or negative, I can leverage any number of options strategies using Calls or Puts.
Finally, I could buy or sell 1 Emini futures contract on the S&P 500 which is worth either 500 long deltas or 500 short deltas respectively.
The method used to acquire delta depends on the circumstances. As an options trader and investor I use the product which best fulfils the “delta” needs and provides the best advantages for the given situation. Using these products without the option component would mean they are 100% dependent on directional move in your favor for profit. The Profit Effect way always looks to combine an option trade or spread trade between two assets for a majority of trades taken. The key is to always give myself as much edge as possible so I’m always looking to use some kind of option strategy around the delta position. The end game is to sell option premium against most if not all of the delta that is carried.
Beta Weighted Delta
Another fact that we’ve covered previously when it comes to delta value is, not all delta is equal. Delta must be made relative. It must be given context or a baseline in order to measure risk. Most US investors use the S&P 500 index as the baseline to measure a single investment or portfolio of investments against. This index contains the 500 largest companies traded in the US and is considered the US broad market index.
Some market prices move together in varying degrees called correlation. Some market prices move opposite of each other, this is called negative correlation. Correlation between assets is measured using beta. Markets with perfect correlation have a beta of 1.0, while markets with perfect negative correlation have a beta of -1.0.
Beta can be used to measure the delta or directional risk of any given position or a portfolio of positions relative to the broad market. When looking at delta this way it is referred to as being beta weighted. This is the lens we use when looking at any delta value. All delta must be beta weighted to see true systemic, broad market risk. tlt
Let’s go through some examples looking at beta weighted delta values. The platform uses the S&P 500 as the default for the beta baseline.
You can see the index measured against itself, is a perfect 1. Some stocks, such as Tesla with a high positive beta of 1.23 has historically experienced price correlation up or down in excess of 23% compared to the broad market. Or, Netflix with a beta of 1.36 experiences 36% larger price moves than the the broad market index. (Figure 1)
If, adjusting for share price, an investor acquires 100 long deltas in the broad market ETF SPY with a beta of 1.0, and 100 (adjusted) deltas of TSLA with a beta of 1.23 and 100 (adjusted) deltas of NFLX with beta of 1.36, the portfolio will have a beta weighted broad market directional risk like being long 359 deltas or shares the broad market . SPY (100) + TSLA (123) + NFLX (136) = 359. The investor is long 300 deltas but theoretically speaking it’s as if being long 359 shares when it comes to broad market risk. This means an already high directional risk is even higher than the investor probably realizes.
On the other hand, look what happens when you mix the beta weighting of delta exposure in a portfolio. Negative beta assets can be acquired like US Treasuries, ticker TLT with a beta of -.58 and the Japanese Yen ticker FXY with a beta of -.26 or Gold which is just about neutral when it comes to market direction with a beta of -.05.
If, an investor was to acquire 300 deltas like in the previous example, but with a different allocation when it comes to the beta weighting. This time they are (share price adjusted) long 100 deltas in the broad market with a delta of 1.00, 100 deltas of US treasuries with a beta of -.58 and long 100 shares of the Yen with a beta of -.26. This 300 delta portfolio weighted against the broad market would carry directional risk similar to being long 16 shares. SPY (100) + TLT (-58) + FXY (-26) = 16.
Now, you may be wondering how a portfolio with such limited directional exposure can ever make any money. Hold that thought for moment and go back to what I said earlier about being agnostic to how we acquire the deltas. In addition, think about the core focus at Profit Effect when it comes to the type positions being placed. The core focus is credit based strategies. The type of strategies that derive profit from time decay. Remember, long or short delta positions can be created using credit based strategies. This means an option trader can construct positions in a way that exploits the ability to make money from credit based strategies while controlling the broad market risk or directional exposure of the account.
In essence, the trader is being paid through the selling of option premium to acquire the delta exposure. They are trading delta for cash. However, the trader has the freedom to allocate the delta exposure to wherever they wish. If they allocate the delta or directional exposure in such a way that greatly limits their risk to broad market crashes but at the same utilizes the advantages associated with acquiring the delta with short options, a cash creating investing process is created.
The implementation of this philosophy entails the constant management of the beta weighted delta exposure, using the best cash creating option strategies possible based on the situation. The options strategies used can be as simple as selling puts to acquire long deltas in a particular market or selling Calls to acquire short deltas in a particular market.
Let’s look at at an example of how an investor can enter and then “cash flow” stock investments in the ETF, Precious Metals, Bond, Currency and Foreign markets using the philosophy outlined
Cash Flow Strategy
A simple cash flow strategy can be created through the activity of entering and exiting positions in the various markets. There are many ways to accomplish this. We’ll cover one simple method here as an example. An investor can use the construction of a balanced portfolio as guidance for entering and exiting positions. The process uses options as the vehicle for establishing and closing the positions and is designed to create cash flow from the activity.
The first step is to lay out a basic plan for the asset class or market sectors which will be represented by the portfolio. A portfolio can be designed around the concept of beta weighting which will ultimately drive the investment decisions. For this example we’ll use ETF products using sectors and commodities to create positions as a strategy versus the traditional method of simply buying a stock or mutual fund as an investment.
Rather than simply buying a stock or fund which represents a position in the stock market, the option trader can create a cash flow investing strategy. This can be done by allocating part of the available funds to individual sectors and asset classes within the broad market and using short option strategies to enter and exit the positions.
Let’s say, instead of buying the S&P 500 itself, the investor broke up the investment into a handful of the main sectors. The investor could create several positions using sector ETFs which together create a portfolio that is diversified across a mixture of assets.
An example of positions may include the financial sector as represented by the XLF, the Healthcare sector XLV, the utilities sector XLU, the real estate sector IYR , precious metals via GLD and US treasuries via TLT.
The size of each allocation can be adjusted to create the “beta weighting” the investors desires for the portfolio going forward. Entry and the future exit of each position is established by using a short option strategy. Ultimately, the price direction any of the particular positions experience is irrelevant to the strategy. The profit is made from the option premium received from the entry and exit activity. Once the position is established it can swing back and forth from a long stock to a short stock position with an equal number of shares. Options are used to enter and exit the positions creating the option premium payments.
The option strategy which is used depends on the particular directional exposure the investor desires for the particular asset class. If a bullish position is the goal then short naked Put options will be sold for entry. If a bearish position is the goal, then short Calls can be used for entry and if the trader has no preference as to whether the position created is bearish or bullish then a short straddle can be used.
Let’s go through an example of how the process works. I’ll go through a simple demonstration using one of the ETFs to show how this cash flow strategy can be carried out. The process can then be duplicated and used to establish a variety of different positions within the portfolio.
We’ll use the real estate sector ETF for the example although this works in any market. The process is actually quite simple.
When an opening position is being established, the investor must decide if they care whether they end up with an initial bearish or bullish position. It only really matters based on how the current portfolio is positioned and that ultimately drives the decision.
For this example we’ll pretend there are no other positions yet. If this is the case a strategy that is directionally neutral can be used to establish the position. This means we don’t care whether we end up bullish or bearish upon the original establishment of the position. In this case my favorite strategy for creating this type of cash flow can be used which is the Short Straddle.
Another detail that needs to be decided is the maximum number of shares to be held in each position. Let’s say for this example it’s 100 shares.
The cash flow strategy is started by selling a short straddle in the particular market. The details for constructing a Short Straddle was covered in the January 9th 2017 edition of Profit Talk“.
Sell a straddle that is closest to 45 days ‘till expiration. A short straddle is created by selling 1 ATM Call and 1 ATM Put, same strike and same expiration.
Selling a straddle at the $79 strike price which will represent a future bearish position or bullish position in the amount of 100 shares will bring in $279 of cash. (Figure 2) After the Short Straddle order is filled, all the investor does is wait the 46 days until expiration. If IYR is above $79 per share on expiration a -100 share position will be created.
In that case, the investor immediately sells 2 OTM Put contracts below current price. Let’s say when expiration occurs IYR is around $81 per share. The trader can now sell 2 OTM Put contracts below current price. If they chose to sell the $79 strike Puts around 45 days ‘till expiration, they may receive about $60 each Put, so $120 in premium. Once they sell the 2 Put options there is nothing to do but wait for expiration.
If on expiration, IYR is above $79 still the Puts will expire worthless and the -100 shares will still be held which means another 2 OTM Puts can be sold. If IYR is below $79 on expiration then 200 positive shares will be assigned to the account but since the account is negative 100 IYR shares, the net result will be 100 positive shares being held in the account.
At this point, the trader can go ahead and sell 2 OTM Calls against the 100 long shares and collect the associated premium. If the share price is below the short Call strikes, the Calls expire worthless, the premium is kept and 2 more Calls can be sold. If the shares are above the strike of the short Calls upon expiration, 200 negative shares will be assigned and the 100 positive shares in the account will result in a net position of -100 shares being held.
This process can be repeated over and over again for as long as the investor wishes. The same process can be duplicated across a variety of different markets to create a portfolio of positions.
The type and quantity of shares held can be adjusted based on the beta weighted deltas held in the portfolio. The continuous application of this process results in an amazing cash flow strategy that derives profit from the entry and exits of positions in a portfolio.
The top takeaways this week are:
First, learn to be agnostic to the source of your delta exposure. Use the best vehicle for achieving the delta exposure based on your circumstances.
Second, always look at your delta exposure through the lens of beta. Use this important measuring tool to evaluate your true risk to a market meltdown and manage your positions accordingly.
Third, use cash flow entry and exit strategies to churn positions and create profit. A simple shirt in the way you look at investing can create success without being right on market direction.
This past week in the broad markets we have at least seen some two sided price action. We have not made much progress in either direction, but have had at least some volatility. Also, the VIX fear index has actually held on to some it’s gains made late last week. This hints that there is at least some fear for the possibility of a move lower, which in recent months has not been a concern based on the continuous drop in volatility. This has been somewhat tempered at least for the moment.
The high impact reports due out this week include:
Monday 4/10/17 - Fed chair Janet Yellen has a speech at 4:10 pm eastern
Wednesday 4/12/17 - the Crude Oil Inventory numbers are released at 10:30 am
Thursday 4/13/17 - Unemployment claims and the PPI - producer price index numbers will be released at 8:30 am . Plus consumer sentiment at 10:00 am
Friday 4/14/17- CPI the Consumer Price index numbers, which is an inflation indicator and the Retail Sales number being released at 8:30 am eastern
As always these reports and speeches have the ability to move markets and create opportunity for the trader who is prepared.
Remember, success comes when opportunity meets preparedness.
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.