Options TradingPortfolio Balance and Beta Weighting
In this article, we’re going to talk about portfolio balance and beta weighting. These are probably two of my most favorite topics to discuss because not a lot of people cover them, yet they are insanely important for your ability to be successful in trading. Understanding these concepts is crucial to focus and streamline your trading efforts. As we’ve covered previously, it doesn’t matter which way you trade the markets with options because you’ll get virtually the same probability of success and payout regardless of the direction.
In one of our previous discussions in track two, we proved this with an example in GDX, where we showed that if you make a 70% chance of success trade in any direction—bullish, bearish, or neutral—you basically have the same win rate and the same payout and risk. This means that it doesn’t matter which way you trade the markets. Now that we’ve talked about trade size and allocation, you know that if you keep your position sizes small, you really can’t blow up your account. However, this doesn’t mean you can be a perma bull or perma bear.
What this means is that you can’t just trade everything bullish or everything bearish. You have to be a little smarter about how you allocate your portfolio. Could you do it and probably make some good money? Yes, and it would be very simple. But we want to layer on these protection filters for our portfolio to ensure that we make money regardless of where the market goes.
The Concept of Portfolio Balance
The first concept I want to talk about is portfolio balance. If you have watched any of our videos before, listened to any of our nightly strategy calls, or any of our previous content, you’ve likely heard me talk about portfolio balance. For me, portfolio balance is a key concept because it gets to the heart of how you can be a non-directional trader and make money in any market direction.
Portfolio balance involves spreading risk across different underlying securities, option strategies, and multiple contracts. This means not being 100% focused on one stock or one type of option strategy. Instead, you should spread your portfolio across different avenues and areas. This includes not only different securities like ETFs and stocks but also diversifying into things like oil, gold, bonds, or other assets if possible.
In terms of option strategies, don’t just trade only credit spreads. Try to include some iron condors, calendars, or strangles if you can. Additionally, use multiple contract months. This means having a staggered set of contracts—some trades for the current expiration cycle and others for the next cycle. This creates a rolling basis of potential income from your options trades.
Real-Life Example of Portfolio Balance
To prove the concept, let’s use a live example from my own trading account at Options America. In my position statement, you’ll see we have trades grouped by strategy—put debit spreads, call debit spreads, credit spreads, calendars, butterflies, iron condors, strangles, straddles, etc. We have a good mix of strategies and a variety of different ETFs and stocks.
For instance, we have major market indexes like the S&P 500 and the Qs, as well as popular ETF stocks like Apple and Qualcomm. We also have other ETFs like XLF, XOP, EWZ, and EWW. This variety helps spread risk. We don’t have all our trades in one stock like Apple or Chipotle. This diversification is crucial, and there’s no perfect formula—just aim for a good distribution across different assets and strategies.
The Importance of Beta Weighting
Beyond portfolio balance, another key concept is beta weighting. In my opinion, beta weighting is the best way to ensure that whatever combination of trades you come up with is net neutral to your benchmark index. This means that your portfolio’s overall movement will align with a benchmark index, which in my case is the S&P 500 ETF (SPY).
Beta weighting takes all the different securities in your portfolio and converts their relative movements to the benchmark index. It gives you a clear view of how your entire portfolio would behave as a single position in the benchmark index. This helps you understand your overall exposure and adjust accordingly.
How to Implement Beta Weighting
In most broker platforms, you can implement beta weighting by using the analyze tab. For instance, in thinkorswim, you type in the symbol for the benchmark index (e.g., SPY) and select the option to view your portfolio beta-weighted. This will show you how all your positions combined would perform relative to SPY.
The payoff diagram will show you the expected profit or loss of your entire portfolio at different price points of SPY. For example, if SPY trades at 190, 200, or 210 by your expiration date, the diagram will indicate your overall portfolio’s performance.
Practical Application of Beta Weighting
Let’s look at a practical application. Suppose SPY is trading at 203.12. Your portfolio’s breakeven points might be between 180 and 211. This means that as long as SPY trades within this range, your portfolio should be profitable at expiration.
If SPY trades at 190, your portfolio might show a profit of $2,000. This gives you a clear target and helps you understand the combined effect of your trades. You don’t need to worry about individual trades as much because you’re focused on the overall portfolio performance.
Balancing Your Portfolio with Market Movements
The goal is to ensure that your portfolio remains balanced and neutral. For example, if your portfolio is currently bearish and the market moves higher, you should add more bullish positions to balance it out. This means trading in the direction of the market.
When the market makes a significant move, such as a large drop, many traders mistakenly add more positions in the direction of the move. Instead, you should respect the market’s move and adjust your portfolio to maintain balance.
The Concept of Delta Neutrality
Being delta neutral means having a portfolio that doesn’t favor a particular market direction. This involves adjusting your positions so that your portfolio’s profit curve peaks around the current market level. For instance, if your portfolio is naturally bearish and the market moves higher, you should add bullish positions to balance it.
If the market moves lower, your portfolio might become naturally bullish, and you should add bearish positions to balance it. This ensures that your portfolio remains neutral and reduces risk.
Maintaining Neutrality and Balance
Maintaining neutrality and balance is a constant process. If the market moves, you need to adjust your portfolio to stay balanced. This involves regularly reviewing your portfolio and making necessary adjustments.
For instance, if your portfolio is naturally bearish, you need to add bullish trades to balance it. This might involve looking for candidates that fit your bullish criteria and making trades that align with this direction.
Questions to Guide Your Trading
To ensure you maintain a balanced portfolio, regularly ask yourself these questions:
- Is my overall portfolio neutral to the SPY?
- What trades do I need to add or remove to maintain balance?
These questions will guide your trading and help you stay focused on maintaining a balanced portfolio. By doing this, you can ensure that your portfolio remains profitable regardless of market movements.
Conclusion
In conclusion, portfolio balance and beta weighting are essential concepts for successful options trading. By diversifying your trades and using beta weighting, you can ensure that your portfolio remains balanced and neutral. This reduces risk and increases the likelihood of profitability in various market conditions.
Thank you for taking the time to read this article. Your thoughts and experiences are valuable, so please leave any comments or feedback. If you found this article helpful, consider sharing it with others to spread the knowledge. Wishing you success and confidence in your trading journey. Until next time, trade smart and stay focused!