not the type of volatility for which the strategist had hoped. Possibly a bit more alarming is that as SPY moved 2.35 points higher, thetrader would actually have given back some open profits. Remember thaton the day of our initial adjustment, had the trader removed the entirestraddle, a profit of $500 would have resulted. Since that time, the pricevolatility has resulted in choppier trade, with decreasing implieds andmovement toward the strike price of the option, none of which help tomake the straddle any easier.Is our strategist wrong? No, but while he has been consistent withhis rules and methodology, the market action that led to initial profitability has now worked against the trade. Fortunately, since it is late October, a strong seasonal period is about to begin that may help. Recallfrom Chapter 10, November 1 begins a bullish period for the market. Inaddition, on October 19, the SPY staged a high-volume reversal, whichsuggested that sellers had been washed out of the market (see Figure13.6). Time to get bullish.With new evidence weighing in suggesting a seasonal rally is coming,the strategist sees that opportunity may exist by getting a bit more bullish.However, let’s say that the strategist is not fully convinced of the magnitude of a potential rally and is concerned over a slow move higher. Remember, at its absolute worst, a move to $123 could result in a loss of$1,100 at expiration. While that is still only slightly more than one-third ofthe initial straddle risk, the strategist is intent on minimizing risk andseeks to profit if SPY moves back toward the 123 strike.What this means is that the trader needs to transfer his existing riskdown to a lower strike that will expand in price if movement in the under-
FIGURE 13.6 SPY High-Volume Reversal (Source: www.ProﬁtSource.com)
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lying does start trending higher. By selling the five December calls and theremaining two December puts at the end of the day on October 19, thetrader could have exited the straddle for a net profit of $295. At the sametime, the strategist is looking to take on a delta long position that willstand to profit from a move higher without worrying about time decay.While we have discussed theta risk and how it works to the detrimentof long premium as the final 30 days of an option’s life are at hand, thestrategist needs to remember that ITM options in this situation are moreof a delta concern to the trader. If the trader has a technical reason thataccounts for time and price when looking at directional risk, the tradermay find that the strongest suitability exists with such option purchases.In our situation, with 30 days left until the November expiration and astrong seasonal period forthcoming—a powerful signal for the short to intermediate term—this looks to be a very appropriate position adjustment.It is a complete transition to accommodate changing market circumstances that the trader acknowledges, and one that is consistent with hisoutlook and risk. That is, we have turned the profitable straddle into anaggressive play in anticipation of the move higher. The SPY November 118calls for 3.20 offer a suitable risk/reward profile based on delta positioning, maximum risk, and stop-loss exposure. A purchase of four contractsis completed after removing the December straddle—this is shown in therisk/reward profile in Figure 13.7.
FIGURE 13.7 Adjustment into November 118 Calls (Source: www.Optionetics.com Platinum)
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The position shift to a call position might be considered a simple onebased on the market circumstances and how the trader wants to benefitfrom it. But that’s the point of adjusting in the first place. There is no standard to follow except that a well-conceived position should realize thetrader’s expectations and keep to the plan of setting up stronger risk-toreward profiles whenever possible. Sometimes the market will be whollyuncooperative and offer only the opportunity to minimize open positionlosses. At other times, as with the price action the SPY afforded duringthis time period (and depending on a trader’s style), opportunity mightmean adjusting, reducing one risk, while shifting into another and attempting to decrease the maximum loss exposure.Thus far, by following fairly simple pattern rules and interpreting market action, the adjustments and repositioning have yielded very negligiblenet profits. In fact, the $295 wouldn’t even cover the cost of one contractof the November 118 calls at a price of 3.20. But the trader’s adjustmentshave done a good job of shifting and reducing position risk while aligningit with the current market conditions. With the latest adjustment thetrader has slightly lowered the maximum risk to $985. More exciting isthat given the fresh market circumstances, the trader has moved hisbreakeven downward and opened up his upside reward dramatically toreflect this situation.This time around the position adjustment works. After further erratic price volatility for a week and a half following the first adjustment,the broader indexes finally rallied. By November 15 the call purchaseperformed according to plan and had unrealized profits of $1,135 (seeFigure 13.8). While the original purchase did entail buying some extrinsic premium, the higher delta component of being already slightly ITM atthe time more than compensated and delivered a profit.On a side note, had the strategist stayed with that delta neutral position—the adjusted December 123 straddle (five calls and two puts)—theperformance would not have been nearly as good and it would be decision time. Consequently, the decision to adjust the position risk from oneriddled with potential decay versus a harder directional delta was a goodone. With the SPY closing at 123.24, the straddle has only yielded $125,but it still contains $1,100 of premium risk. There are now 31 days untilexpiration. Since it is an ATM straddle once more, a strategist still holding this position might be inclined to take further action and, at a minimum, roll out the position away from these time-sensitive options thatare becoming increasingly affected by time decay. So the adjustment to along call trade was clearly the right move. It shifted the risk from beingpinned to the 123 strike price at expiration. It also accounted for thechange in the VIX and the bearish sentiment that had developed from lateSeptember to mid-October.
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FIGURE 13.8 Risk Graph on November 15 (Source: www.Optionetics.comPlatinum)
DELTA BUTTERFLY ADJUSTMENTNow the trade is in a profitable position with expiration around the corner—it includes four SPY November 118 Calls. If the strategist does nothing, he might be faced with owning 400 shares of the SPY, which formargin purposes incurs a great deal more capital. So what are the trader’sremaining options with this position? One might be compelled to at leastbook most of the profits while still trying to maintain a bullish positionsince further bullish seasonal tendencies exist. In this situation, a bullishlypositioned butterfly looks to offer a suitable risk/reward profile headinginto the November option expiration.The decision the trader needs to make in adjusting his SPY position isgoing to have to answer the questions how much, where to, and how long.In answering how much, the trader wants to keep profits that have beenmade. It is the same philosophy of scaling out of winners, which providesa trader with potential to ride winners further without having the risk ofgiving back profits. In this case, we’ll assume a risk of 30 percent or about$350 of the profits after closing out the November 118s for 5.30.In terms of the second question, where to, the trader needs to determine the point to which SPY will move. Another issue is how it mightmove; depending on the situation, a gamma trade (straddle) might be considered. However, because the trader is seeking to enter a position with
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very little capital at risk, the straddle is already a very unlikely candidate.With December options pushing the 30-day theta threshold, January options seem to be the better choice, but they come with additional extrinsicvalue in the form of a higher initial debit. With the ATM straddle offered at$495, that’s already more than what our strategist is looking to commit.Getting back to a bullish delta butterfly, this is a strategy that can beimplemented effectively using December options. With smaller debits andhigher risk-to-reward ratios, the trader doesn’t have the theta concernwith this limited-risk position. Furthermore, with one-point strikes, thestrategist has many variations at his disposal—establishing an appropriaterisk/reward profile is easier. The downside to this strategy might be thatwe are looking for a definite range within which the underlying has to fallwhen expiration occurs. Remember that above and below our strikes, themaximum loss (our debit) will be realized. So let’s take another look at theSPY on November 15. However, this time, let’s try to gauge a price zoneand then find an appropriate fit, given the initial risk assumption.From our charting software, we estimate that the most significanttechnical resistance level is roughly $126.50 a share, and we expect theSPY to gravitate toward that level by December expiration. Based onthese expectations we adjust again, this time developing five bullish butterflies using 124 and 128 as our wings and 126 in the body. This happensto line up quite nicely with the targeted range (see Figure 13.9).What a difference a day can make! Sometimes that’s all it takes for aposition to shift gears for the better. And sometimes, the opposite is true ifthe strategist isn’t diligent about making necessary adjustments when
FIGURE 13.9 SPY Price Projection on November 15 (Source: www.ProﬁtSource.com)
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FIGURE 13.10 Bullish Butterﬂy, December 124/126/128 Calls (Source:www.Optionetics.com Platinum)
opportunity presents itself. In this situation, one day did make a substantial difference for the holder of the bullish butterfly. It actually turned intoa bearish delta on the eve of the December option expiration. Price actionthat week just breached the top of the resistance zone before a hard pricereversal on expiration day resulted in a closing price of 126.36. The butterfly, which cost $0.70, or $350 for five contracts, would have netted an additional $470 for the trader (see Figure 13.10). However, as the risk graph inFigure 13.8 can attest, the trader in this position was in fine shape, regardless of the underlying price action.
CONCLUSIONAs every good chiropractor knows, adjustments work. They don’t alwayslead to profitability, but by moving or eliminating position risk to reflectchanging market conditions, the successful options strategist continuallystrives to shift the risk/reward profile further in his or her favor. With risksranging from time decay for the straddle player to pure directional risk(albeit limited risk), the option strategist who looks to adjust is also thetrader poised to achieve healthy results over the long run.
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We trust that the adjustment process shown in these working examples in the S&P 500 ETF (SPY) also demonstrate why these instrumentsmight be strong choices for options trading. We shifted from a delta neutral straddle, to adjusting directionally for an anticipated technical event,to taking advantage of tight strikes by developing a stronger butterfly profile. It is our anticipation that those types of opportunities will continue tomake the case for options trading in index and sector proxies.
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RiskManagement
M
aking adjustments to positions goes hand in hand with risk management. In the previous chapter, we saw how to adjust a winningposition based on changing circumstances. Sometimes, however,we are forced to adjust losing trades. This can mean exiting a position at aloss, which is not always an easy thing to deal with. In fact, studies haveshown that the emotional pain and stress from a loss is greater than theemotional lift received from a winning trade. In order to avoid the painfrom losses, we obviously want to develop a game plan that generatesmore winners than losers. We also want to use strategies that have highpotential rewards with relatively limited risk (those strategies have beencovered earlier in this book).Another important consideration is risk management—understanding what needs to be done in order to limit the number of losses and,more importantly, limit the percentage lost relative to the portfolio’svalue. This is ultimately a personal decision. No one else can tell youhow much you are comfortable risking on one trade, in one week, or onone position. There are no hard and fast rules about risk tolerance. Nevertheless, managing risk is a key part of any trading plan because alltraders deal with losses. In fact, some very successful traders will tellyou that they are not great traders; they are great risk managers. Riskmanagement helps remove the emotional responses that sometimeslead to irrational decisions. This chapter explores some strategies thatwill help you become more proficient at this very important aspect oftrading.
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OVERVIEWNo market approach is complete without a discussion of money management, which includes personal financial management. The topic can beall-inclusive, covering each step along the way from financial planningthrough managing an individual trade. It can also cover different types ofinvestors and traders. Our primary focus is money management for indexbased trading, but many of the same principles apply to a variety of tradeapproaches. We begin with a brief discussion of asset allocation and riskmanagement as it applies to investors, but we focus on trade management. We examine diversification and why it is important and then closeout the chapter with a discussion of risk management as it applies to indextrading (see Figure 14.1).An individual needs to consider several factors when making a decision about which markets to invest or trade in. There are several marketsto choose from—stocks, bonds, precious metals, energy, real estate, foreign exchange, and so on. Ultimately, the decision is guided by severalconsiderations, including the individual’s (1) knowledge of those markets,(2) total assets available, and (3) risk tolerance.Since this financial markets decision is based on highly personalfactors, it is up to each individual trader to determine which marketsare most appropriate. Knowledge of the markets is obviously importantand reading books like this one is a good first step. More importantly,new traders will want to track the market to get a feel for it over time.
Overall Allocations
Daily Needs
Investments
FIGURE 14.1 Asset Areas Requiring Our Attention
Trading
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Different financial markets can behave very . . . well, differently. In addition, market conditions change over time. The more hours spentstudying and observing a market, the better the knowledge base inwhich to begin.In addition, traders must also decide whether to invest in a specificmarket or to trade it. A general rule of thumb is to trade only one or twomarkets at a given point in time, which will allow sufficient time to analyze and monitor conditions. It is very difficult to study and trade morethan two markets simultaneously. As an example, an investor mightchoose to trade stocks and options. For most investors, there are simplynot enough hours in the day to try to trade stocks, bonds, futures, foreignexchange, and the options market all at once.Our discussion of risk management focuses on the U.S. equity market,looking at important elements that relate to both investing and trading.While these general concepts can be applied to other markets as well, thereader must be sure to understand the unique risks and characteristics ofany given market. Each market is different and offers varying risk/rewardopportunities. For now, our focus turns to risk management in the U.S.stock market.Cash Is KingMaintaining some cash on hand never hurts. Readily available cash provides ammunition for that sudden, unexpected trading opportunity. Moreimportantly, it can serve as a cushion or buffer in one’s portfolio. In thatrespect, cash can help reduce the stress associated with having an entireportfolio invested in the market—particularly when large declines are encountered. Cash should be held in interest-bearing accounts, such asmoney market funds.
INVESTMENTSCreating a solid financial investment plan is an important first step. It addresses two needs: (1) allocations for the long-term, and (2) allocationsfor trading. The term allocation refers to the amount of capital a traderwants to commit to a specific market. For instance, if my account consistsof $100,000, I might move $40,000 to an investment account, $40,000 to atrading account, and keep $20,000 in a money market fund.Having a plan for long-term assets as well as specific funds sidelinedfor the purpose of trading can significantly reduce trading stress. Withinboth the trading and investing accounts, diversification can occur on a
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few different levels. Diversification means investing or trading within different assets and/or groups. For example, one can diversify across markets, followed by sectors, and finally industries (see Figure 14.2). Bytaking a systematic approach to diversification, you can more easily benefit from stronger markets and capitalize on opportunities as they arise. Atrader who understands indexes, as well as the securities that track them,has some powerful diversification tools at his disposal.The primary goal of the next few sections is to introduce a frameworkthat traders can use to measure investment performance of long-termassets. Once a plan is put in place and monitored separately from tradingactivities, the individual can focus on their shorter-term outlook and tradewith less distraction.Why do investors diversify at all? There are two primary reasons:1. Markets do not move in the same direction at the same rate, and2. It is very difficult to time the markets.
We’ll discuss each of these reasons shortly, but first let’s revisit twotypes of securities available to investors who make use of an indexapproach to the markets.A hypothetical investment portfolio might consist of mutual funds(MF) or exchange-traded funds (ETFs). Both can serve as proxies forbroad markets, sectors, or industries. As we saw in Chapter 8, there areadvantages and disadvantages to each. On the one hand, ETFs generatemore costs in the form of commissions. On the other hand, these securities also add a great deal of flexibility for trading. Unlike mutual fundshares, there is no short-term redemption fee if an individual chooses to
Industries
Sectors
Markets
FIGURE 14.2 Diversiﬁcation via Index-Related Securities Occurs on Various Levels
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sell an ETF within 90 or 180 days. Additionally, an ETF investor can usebasic option strategies to increase income for a position or create a partialor full hedge when markets decline.Mutual fund investors have a very long list of prospective fundsfrom which they can select. According to the Investment Company Institute (ICI), as of November 2005, there were more than 4,500 stock mutual funds in existence and nearly 8,000 mutual funds in all. Theoverwhelming numbers of funds can be a double-edged sword; not onlyis “analysis paralysis” a possibility, but one cannot assume that all fundsact the same.Those interested in an index approach to investing need to seekfunds that are passively managed to obtain the best index proxies.Many of these so-called index funds have a “no transaction fee” ratewith low expenses (recall the discussion on passive investments). However, other fees may apply to such investments. Individuals should consider using a fund screener to reduce the list of potential candidates forinvestment. Keep in mind that most of the strategies presented in thisbook involve the actual index (with options) and ETFs, not mutualfunds. There are occasions from an investing standpoint when the market you wish to track does not have an associated ETF—maybe just notyet. Table 14.1 recaps some of the differences between these two different types of funds.As with any investment, a key to successful use of index proxies ishaving a thorough knowledge of the instrument itself. For example, whendoes it make more sense to trade the SPDRs compared to the Vanguard500 Index mutual fund? Be sure to understand the risks of the instrumentas well as what drives its movement. Finally, consider tax impacts of boththe instrument and the type of account in which it is held. All of thesedecisions are related to money management and can significantly impactinvestment results over the long term.
TABLE 14.1 Passive Mutual Funds and Exchange Traded Funds—Quick ComparisonPassively Managed Mutual Funds
Exchange-Traded Funds
Index proxy
Index proxy
No transaction fee available
Transaction fees (commissions)
Low management fee available
Low management fee available
Short-term redemption fees
No short-term redemption fees
Very large selection
Growing selection
No options available
Options available
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DIVERSIFICATIONDiversification is an important part of any investment strategy. Marketssimply do not always move in tandem. In fact, sometimes they can behavevery differently. The statistical way to say this is that markets are not perfectly correlated and may actually be negatively correlated (one moves upwhile the other moves down). In addition, volatility can vary a great dealfrom one market to the next.A simple look at various charts bears this out. For example, Figure14.3 shows the very different price action of the Dow Jones Transportation Average ($TRAN) and the PHLX Oil Service Index ($OSX) in 1999. Attimes, one moves higher and the other moves lower. It’s relatively easy tosee the correlation between two index proxies using charting softwarethat allows overlay charts. Optionetics Platinum and other software packages have also been developed to help investors search for correlated andinversely correlated indexes.Correlation AnalysisCorrelation is measured on a scale from 1.00 to –1.00. A reading of 1.00indicates that two assets are perfectly, positively correlated while –1.00indicates that two investments are inversely correlated (perfectly, negatively). A reading of 0 suggests no correlation. When the correlation is ator near zero, the investments are said to be uncorrelated.
FIGURE 14.3 Daily Chart for Dow Transports and OSX (Source: www.ProﬁtSource.com)
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The only way to truly diversify your portfolio is to understand (1) theextent to which it is currently diversified, and (2) how any new prospectsare correlated to existing positions.Using securities that are strongly positively correlated to a basket ofdifferent market indexes can provide an element of diversification. Forexample, owning shares of the iShares Long-term Bond Fund (TLT) andthe Street Tracks Gold Fund (GLD) will add an element of diversificationto a portfolio that previously only included an S&P 500 fund. As was notedin earlier chapters, the TLT holds government bonds and the GLD holdsthe precious metal. While it isn’t possible to diversify market risk awaycompletely, traders head toward that direction when they understand thetypes of investments in their portfolio and how those move in relation toone another. Remember, there is always a bull market somewhere (andlikewise a bearish one as well).
Food for ThoughtWhich portfolio is riskier: one that is 100 percent invested in a single security, or a second portfolio that is invested in four securities that are notperfectly correlated? Remember, the question is not which will have thebetter returns—the question is, which is riskier? If you answered that theﬁrst portfolio is riskier, then you have a basic understanding of the statistical concept of correlation and how it applies to risk. The ﬁrst portfolio isriskier because when the one holding in it declines there is nothing todampen the impact of that decline. Imagine that one security was Enronstock in the early 2000s . . .
Difficulty in Timing the MarketsSince there are so many sectors and securities available to an investor, atop-down approach that evaluates markets first, then sectors and smallersubgroups, can be used to create a portfolio. Chapter 12 offered an example of compartmentalizing the market with the Select Sector SPDR funds.From there, the market can be dissected further in terms of specific industry groups.One approach to investing is to create allocation ranges (see Table14.2) for the different asset classes an individual chooses to use for diversification. This can include diversifying among markets such as stocks,bonds, and commodities; spreading risk across sectors; or allocatingmoney to different groups such as value and growth stocks.
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TABLE 14.2 Illustrative Benchmark Portfolio with Allocation RangesAssetClass
Performance Benchmark
AllocationRange
SampleAllocation
Stocks
S&P 500
40–65%
40%
Bonds
Lehman Aggregate Bond Index
15–45%
25%
Commodities
DJ-AIG Commodity Index
15–45%
20%
Cash
T-Bill Rate
5–20%
15%
Portfolio Ranges and Benchmark(For Illustrative Purposes Only)The example in Table 14.2 does not represent a recommended portfolio.The purpose of this example is simply to show you one way you can identify allocation ranges for your investments. Portfolio development is anextremely personal process that blends an individual’s constraints (timehorizon, liquidity needs, taxes, etc.) and preferences (risk tolerance),along with knowledge of various markets. A one-size-fits-all approach toallocations does not exist.Assuming the base portfolio shown is appropriate for a certain individual and that the indexes provided are good benchmarks for each respective asset class, the next step is to note the performance of this baseportfolio over a period of time. So allocation ranges can vary based on anindividual’s constraints and preferences, while the actual investment levelat a certain point in time is based on the outlook of the various markets.An individual can create a portfolio that incorporates all appropriateasset classes. A portion of total investment dollars available may be invested in major market index proxies that mimic the performance ofthose markets, while other funds are allocated to relatively strong performers within those markets (i.e., sectors and industries). As a result, asthe bullish and bearish trends develop, markets that include stronger performing groups will have larger allocations in the portfolio. This is effectively letting the winners ride.
UNCOVERING POCKETS OF STRENGTHTraders often use relative strength analysis to add outperforming strongsectors and industries to a diversified portfolio. In Chapter 11 we introduced Jay Kaeppel’s Pure Momentum system, which involves buying sector winners at the start of each month. As we saw, this approach handilybeat the market on a consistent basis.
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Constructing and monitoring a relative strength (RS) line and usingbenchmarks with volatilities similar to the security being evaluated canalso help identify outperforming sectors. Using equity analysis, the RS lineis constructed by taking the index level for the sector being analyzed anddividing that value by a broader benchmark index. Some charting packages include flexible RS indicators that allow the user to input any valuefor the numerator and denominator, while others may be more restrictiveon the denominator. However, this line can readily be constructed in aspreadsheet graph by using the following value:RS line value (today) =
Price equity (today)Benchmark index value (today)
A rising RS line means the security (numerator) is outperforming theindex (denominator). A falling RS line tells us the security is underperforming the index. It is very important to note that a rising RS line doesnot imply that the price of the security is rising. It only tells us the securityis outperforming the index. Both could be declining, with the price of thesecurity declining at a slower rate.Figure 14.4 shows a long-term upward move for IWN—the iSharesRussell 2000 Value ETF—which corresponds to a rising RS line on thelower portion of the figure. This fund holds small cap stocks that areconsidered to be in the value category. According to Frank Russell, the
FIGURE 14.4 Relatively Strong Russell 2000 Value ETF versus S&P 500 onWeekly Chart (Source: www.ProﬁtSource.com)
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creators of the index, value stocks in this case are companies with lowerprice-to-book ratios and higher forecasted growth rates. The relativeratio used to construct this line is:RS line =
IWN priceS&P 500 cash level
Although there are periods of decline in the RS line, the long-termview shows one of outperformance for IWN compared to the S&P 500.This fits two of the anomalies discussed in Chapter 10: the size effect andthe low price-to-book effect. A portfolio with heavier weighting toward securities with rising RS lines compared to their appropriate benchmarksdoes not guarantee gains but should at minimum result in dampenedlosses. Such performance should help reduce trading stress.While we can use relative ratios to locate stronger performers (markets, sectors, and individual securities) there is an issue that must beaddressed when adding volatile securities to the portfolio: Once the relative strength relationship changes, it will do so quickly.