Are you diversified?
When considering this question, the first thing that comes to mind is the importance of having a diverse portfolio. Diversification is frequently emphasized as a key strategy for managing investment portfolio risk. Investors aim to reduce the impact of adverse market movements on their overall portfolio by diversifying their investments across different asset classes, sectors and geographies.
Traditional ways to diversify include:
invest in different industries: Allocate investments across different sectors such as technology, healthcare, finance, consumer goods and energy. This reduces the impact of sector-specific risks and allows them to benefit from potential growth in different areas of the economy.
Consider market capitalization: Diversify your portfolio by investing in companies of different sizes. This may include large-cap, mid-cap, and small-cap stocks. Large companies often offer stability, while small businesses may offer higher growth potential.
Geographic distribution: Invest in stocks of various countries and regions. This helps reduce exposure to risks associated with a particular country’s economic and political environment. Consider allocating funds to both domestic and international markets.
asset allocation: Diversify your portfolio across different asset classes including stocks, bonds and cash equivalents. This strategy helps spread risk and balance potential returns. For example, bonds tend to be less volatile than stocks and can provide stability during market downturns.
Include different investment styles: Consider blending growth oriented stocks with value oriented stocks. Growth stocks typically have high potential for future growth, while value stocks are often undervalued relative to their fundamentals. Combining both styles allows you to diversify your portfolio across different investment strategies.
- Allocation across market sectors: Diversify your holdings among different companies within each industry or sector. This helps reduce the risk associated with investing in individual stocks. By holding a mix of stocks within each sector, you can reduce the impact of single stock performance on your overall portfolio.
Do traditional diversification techniques really work? Let’s examine the events of the 2020 market crash for some insight. During market crashes, a phenomenon known as correlation emerges, creating a situation in which all asset classes are closely intertwined. Take advantage of traditionally uncorrelated stocks such as GLD (gold), TLT (fixed income), SPY (S&P 500), AAPL (big tech), BA (aerospace), TGT (retail), LUV (airline) Even in combination, OXY (petroleum) and AMGN (pharmaceuticals) showed high correlation over just two weeks, from March 6th to March 19th.
yes, but it may not help
The performance of these assets during this period was: GLD -12.21%, TLT -11.19%, SPY -19.26%, AAPL -8.8%, BA -62%, TGT -5.4%, LUV -33%, OXY -60%, AMGN -6%. Despite representing different sectors, these stocks all fell at the same time. This phenomenon, which I call “collision correlation”, calls into question the notion of proper diversification. In fact, being invested in these assets is essentially a short volatility position.
This observation raises the question of whether this can be considered an appropriate diversification. In my opinion the answer is no. An investor may own multiple assets, but they all have one thing in common: they are exposed to volatility. As a result, when a crash occurs, these assets tend to move in the same direction, leading to significant losses.
It is important to recognize that traditional decentralization techniques alone may not provide adequate protection during market crashes. To mitigate the impact of crash correlation and volatility exposure, you may need to adopt a different strategy. This includes incorporating assets with real diversification potential, such as non-traditional and alternative investments, and implementing additional risk management techniques such as hedging strategies.
During market crashes, a phenomenon known as “crash correlation” occurs, affecting not only traditional diversification methods, but also those selling option premiums. The common practice of selling implied volatility through short straddles and short strangles with naked puts can result in large losses during a crash. For example, in the March 2020 crash, his $1 SPX put option surged to his $90, resulting in a potential loss of -$90 on trades intended to win $2. Therefore, a $10,000 trade can result in a loss of almost $1 million and cause significant financial stress.
Understanding the secondary Greek word known as “vomma” is a key factor in maintaining portfolio diversification. Vomma is a derivative of Vega that measures the sensitivity of option prices to changes in volatility. When volatility is high, vega increases, leading to higher option prices. Vomma, on the other hand, represents Vega’s exponential growth. More simply, this means that vega, or options, prices can rise significantly exponentially if volatility increases significantly, as seen in crash-style market conditions. To do. By understanding the concept of vomma and its relationship to volatility, we can better manage market fluctuations and strive to maintain a diversified portfolio.
Imagine a scenario where you hold a truly diversifying asset during a market crash. Imagine the satisfaction of witnessing a $10,000 position soar to nearly his $1 million mark. This may be an exaggerated example, but it highlights the potential benefits that can be achieved by implementing the right trade structure and leveraging the benefits of vomma. Focusing on a trading strategy that considers the vomma and its impact may avoid the misconception that the impact of the vomma is well diversified while exposing you to large losses.
Another important factor in exploiting market crashes is the ability to close trades efficiently through single-order trading structures. During a market crash, it’s important to avoid “legging” your trades. This approach carries the risk of turning profits into losses. The process of closing one half of a trade at the same time not closing the other half can expose the market to a reverse move. I personally experienced this disappointing result in his early 2018. The expected profit turned into a significant loss due to the legging out scenario. To provide some more insight into the issue, I created something like this: this video. By understanding the importance of an integrated trading structure during market crashes, you can aim to protect your profits and effectively mitigate potential losses.
Another important aspect of maintaining good hedging is a proactive approach. This means keeping the hedge in place at all times, as waiting can be harmful. It is impossible to predict exactly when a market will crash, so introducing hedging to catch up after volatility has already spiked is a difficult and often unsuccessful strategy. In addition, applying the hedge too late increases the likelihood that volatility will return to its average before the hedge is fully utilized. To avoid such predicaments, it is important to adopt an aggressive hedging stance so that the portfolio is consistently protected regardless of market conditions.
Overall, achieving effective diversification and mitigating the impact of market crashes requires a comprehensive understanding of a variety of factors, including trading structure, volatility dynamics, and proactive risk management. Combining these factors, investors can aim for a more resilient and successful trading system.
About the author: Karl Domm’s 29+ years of options trading experience demonstrates the ability to trade for a living with a proven track record. His journey began as a retail trader, which he finally achieved after struggling for 23 years.
Proprietary options-only portfolio with quantitative trading strategy generated stable returns in 2017.
After building a solid trading track record, he accepted outside investors. His book, A Portfolio for All Markets, focuses on options portfolio investing. He earned his bachelor’s degree from Fresno State University and currently lives in Clovis, California.you can follow him on youtube and visit his website Real PL for more information.