Risky Business - Part Four

In this, the fourth installment of my "mini-series" on portfolio risk management, I bring yet another type of diversification. So far I've talked about Time Diversification and Underlying Market Diversification. I also like to use Strategy Diversification.

What I mean by Strategy Diversification is the type of option spread strategy I put on. Each type of spread strategy has it's own characteristics and it's own risks. So part of risk management is to not get overly lopsided in any one direction. For example, vertical spreads and horizontal spreads have opposite effects on volatility risk. Therefore I can neutralize Vega (to some degree) by blending vertical and horizontal spreads.

Another example is in the area of price risk. For example, in a calendar spread probability of profit is restricted to a much narrower price range than a condor. On the other hand, the yields are generally much better. Blending these two provides a nice balance to price risk management. I also prefer the risk/reward ratio of calenders.

Early on I mentioned that I really only do three types of trades. And each one of these has a purpose.

• Neutral Vertical Spreads (including Iron Condors): These are mainly used for their high probability of profit and good Theta.
• Neutral Calendar Spreads: Used to balance the short Vega of the Vertical spreads, to boost Theta, and sometimes to provide some directional bias.
• Directional Vertical Spreads: I mainly use these to balance my overall portfolio Delta, while adding Theta.

I begin each month by entering trades that are Delta neutral, like condors and calendars, and which balance Vega to some degree. My balance of these varies a little depending on my opinion about the direction of implied volatility. As the month goes on I will enter directional positions to either balance or bias my price risk, depending on my opinion about the market. Hopefully this explains the portfolio balance that I strive for, although I will say that it's very difficult to really be precise. I get as close as I can to a moving target.

Good Trading....