Entering my sophomore year of high school, I decided to relinquish three weeks of summer vacation to take a course in "International Markets and Finance" at Brown. Despite doing what any fourteen-year-old would cringe at, I actually had a lot of fun and learned from my intelligent peers and professor. It was a great introduction into the world of finance and definitely gave me a new perspective at the trading world.
During our coursework, we were assigned a paper trading project in order to make some virtual dough. After competing with other teams in our class, we were going to be evaluated on performance and strategy by our professor.
Our class duration of three weeks was a tiny time frame to measure any kind of performance or skills, because success inevitably laid in selecting stocks and hoping it rallied. What was worse, we couldn't short stocks or trade options, futures, or any derivatives. Given these shortcoming, I dipped into my bag of tricks and tips that I learnt from my trading gurus at TastyTrade and picked 'beta-weighting delta'.
So what exactly is 'beta-weighting delta'?
Beta-weighting delta on a portfolio is one number that can tell us as to how much our portfolio can move up if the index moved up 1 point -- or much our portfolio would move down if the index lost 1 point. While this didn't necessarily help in picking lucky stocks, it did help us watch the impact any of our picks made on our portfolio. While our team didn't win the stock-picking competition, our unique approach to portfolio management won us some accolades from my professor.
In a past post, I previously discussed the important Greek metric: delta. Deltas of an option are the measure of how much the option price would move for a $1 move in the price of stock. While a bit different, the concept of the 'beta weighted delta' of a portfolio remains the same: it answers the question as to how much your portfolio would gain (or lose) for a $1 gain (or loss) in the index that you are beta-weighting against.
So what is beta? Beta is a measure of volatility for a specific stock. This is computed by your trading platform based on historic relations with the index. Different stocks have different betas. Listed below are a few betas:
As you can see, Amazon's (AMZN) beta is 1.48 while that of Facebook (FB) is 0.71. The benchmark index SPY is 1.
Beta of the stock helps us infer the volatility of the stock compared to the index. So Amazon's at 1.48 means it is about 48% more volatile than SPY and if the index rallies up one point, Amazon could rally up 48 points.
Using beta, we can beta weight all of our stocks against the index which in essence would compare a diverse group of stocks into some sort of equivalence using the index. The formula and calculation of the beta weighted delta is as follows:
Consider for example a simple FANGs portfolio in which we have short 30 delta put (that is, we have long bias in the four stocks). Here we have found the beta weighted delta for all four stocks
So if you sum up all the beta weighted deltas of individual stocks, you get the beta weighted delta of your portfolio -- in our example it's 347.05.
This single number gives us a bird's-eye view of the risk in our portfolio . Using this information, we can strategically position ourselves to neutralize our deltas and reduce risk. We could hedge our portfolio against a downturn by selling about 347 deltas worth of SPY which can be done by either straight selling 357 SPY stocks or selling say about 7 ATM calls of SPY (each ATM call is 50 delta).
Note that the beta weighted deltas constantly fluctuate with price so any and all adjustments should be made with the current prices. Most good trading platforms (like TastyWorks) provide these calculations for free so traders can focus on trading and not crunching numbers. Having a basic understanding of this concept will go a long way in managing your portfolio.
Thank you for reading! :)
Welcome back to Cost-basis-reduction- Part Two! In my previous post I had talked about this concept as a core philosophy of trading, investing, or of doing any part of business
In this post, we will look at putting this philosophy into practice. We'll look at some hard numbers gathered over past 8 months or so by a fellow trader.
Let's assume that we have a bullish bias. There are a few routes or strategies we can take when deciding how we'd like to position ourselves:
Let's look at three strategies as a part of our experiment:
Strategy I: Buy stock and hold
Here, we did the simplest of strategies which is to buy a stock and wait for a change in price, also known as buying and holding. Here the investor buys a stock and at a time the investor deems appropriate, he/she sells the stock.
In this example, we bought 100 units of SPY in third week of March 2017 for $238, so the total cost on the trade was $23,800. Currently the stock is about $258.58 which is healthy 8.65% return with absolutely no sweat. Easy enough, right? But is that truly our best option?
Strategy II: Buy stock and sell monthly calls against it (Covered Call)
In this strategy, we did the covered call strategy. We bought the same $238 stock and every month we will sold 30 delta calls for the following month. We chose 30 delta as it translates to a probability of about 50% probability for being ITM one month from now.
On Mar 3rd we bought the stock at $238.25 and sold April 30 delta call at a strike price of $242 for $1.45 ($145). We bought back this same call for free on Apr 20th and sold a May $239 Call for $1.49 ($149). This cycle kept repeating every month.
With every trade, we kept collecting premium by sell calls. And by collecting premium, we kept reducing our cost basis putting us at a gain of about 8.27%.
This is slightly less than the 8.65% gain in previous strategy as there were months when SPY went up too fast causing us to buy the calls back at a loss.
Complete log of the trades is listed as below:
Strategy III: Buy long dated option and sell monthly calls against it
For this strategy, we did a diagonal spread. A diagonal or time-spread is when you buy a far month option while selling a close month option (to be further explained in future post).
In this strategy, we bought 10 ATM Dec calls at a strike price of $238 and paid $11.39 ($11,3900) for each call. Against each of these, we sold 10 calls at 30 delta in the monthly options about 30 days away. Towards the end of the expiration, we bought back the monthly calls and sold the 30 delta call the following month. Like the covered call, the diagonal spread is a similarly cyclical process.
This strategy is also called a poor man's covered call as you might have noticed that we bought a far month call option paying $11,3900 instead of buying the SPY stock itself for $23,800. At about half the price, we are control 10 times more units. Though this strategy comes with more leverage, it also comes with more risk. Nevertheless, the return on this strategy was 89.20% !!
After about 8 months, we can look at how the different strategies fared in the chart below:
The baseline is the white dotted line which is the price that we bought the SPY stock in March at $238.
In the Strategy II and III, we have reduced the cost basis of our stock considerably while in Strategy I we didn't do anything and we are still holding on to the stock hoping that it'll keep going up perpetually. How would Strategy I fare if there's a 2% or 5% pull back? There is no cushion room in Strategy I to recover from this kind of pullback. However with Strategy II and III, both can withstand a mild to modest correction in stock price.
The entire goal of the Strategy II or III is to reduce the cost basis down to zero so that in few years you own the stock free and clear.
Note on commissions: for sake of simplicity, we are ignoring the price of transactions. But I'll note it that it costs about $6 to buy 100 units of SPY. Each option transaction is $1 per trade without any overheads. So you'll see that the cost of entry or exit is pretty negligible for our purposes here.
As a child, many of us have endured the arduous labor that is chores. While all of us have done the dishes and cleaned our rooms, let’s admit it… we were always a little envious of our friends who received pocket money. (Trading makes up for it though, so it’s all good :)) Imagine your friend, king of the playground and loaded with $100. Devastated, he loses $50 by accident. Now consider his dad, who likely earns a couple of thousands per month. If he lost the same $50 bill, it would certainly hurt his pride but not his wallet, as much as his young son’s. If you could choose to be in the son or father’s position, which one would you choose? To lose half of your earnings or a minute fraction? This form of decision making is analogous to that of a trader’s. In this post, we will be learning about trading size in your portfolio.
One of the toughest things in trading or investing is figuring out the size of each trade. How much of your capital should be deployed in the markets and how much do you hold in cash? Let’s take a hypothetical portfolio of $10,000. If you have $10,000 in your trading account, how would you allocate this $10,000 in markets to make your money work for you?
Well, you could pick your one favorite stock (selection made on criteria that suits you) and buy every stock possible for the entire $10,000 and hope that the stock goes up in value and you profit from it. Most traders who start fresh are inclined to do this. While this is an easy way to execute, it’s neither prudent nor profitable to put all of your eggs in one basket. What do you think would happen if the stock took a 20% hit and your portfolio value falls to $8000? You can of course wait for the stock to rally to get back to your initial investment of $10,000. But just how easy is it for the stock to move up in terms of it’s current value so that you can break even? If the stock falls 20% in value, it needs to gain 25% from that point for you to make a profit. If the stock falls 50% then it needs to gain 100% (or literally double it’s value) for you to breakeven. The table and chart listed below shows the non-linear relationship between the gains need after a steep drop for your portfolio to recover:
Alternatively, you could spread your risk and allocate this $10,000 across several different stocks in a manner that exposure of risk to your portfolio is spread across these different stocks. For example, we could allocate $250 per trade/investment and buy or sell 15 to 20 stocks/options. This would be a bit more diversified compared to the previous example but if all the stocks selected are highly correlated to each other, then the impact of the market move in a direction would have same impact as if the portfolio had just one stock as in previous example.
So, a better way of portfolio allocation would be is to add some diversification to your portfolio in terms of having some long positions, some short positions, having a mix of stocks, ETFs, commodities, options that have low correlation between each other. Advanced traders would add diversification in terms of strategies so at that one can benefit from the changes in volatility or direction or time.
Personally, in this extremely low IV environment I'd like to keep 50% of my capital in cash and deploy the other 50% in the market, diversifying it through various underlyings and strategies. The trick is to diversify as much as possible and trade small, but trade often, as TastyTrade would say.
Stay tuned for more posts from NishaTrades!
"Cost basis reduction" (CBR) is a simple but ignored concept when it comes to investing or trading. Consider a case of buying or selling anything in the non-trading world. Let's suppose you were trading baseball cards with your buddies; your prime objective would be to buy the product at the lowest possible cost and then sell it at the highest possible price (that the market would support) and thereby profit on the transaction. If you can't buy the product at a low cost you'd look for an avenue to get the product at the cost lower than what it is being currently offered to you at. If you were a deli store owner and your supplier is selling you vegetables or meat at $1 per lb, you'd always be on a look out to get the same elsewhere at a rate better than $1 per lb as that'll increase your profit margins (assuming your operating costs and selling price is not going to change). In your personal life, you are always looking for that deal to buy that latest gadget for a lowest price possible. If the store has lured you to their location to purchase it a specific discount, you'd always look up the price online to see if you can get a better deal there.
Now in terms of investing, if you had purchased a secondary home or property as an investment, you are most likely to rent it out. It's highly unlikely that you would invest a big chunk of your savings into a secondary home/property and hope that in, say, ten years the property would have appreciated and you'd have sold it for a profit. Imagine two property owners: Bob and Jane. Bob and Jane both invested some savings they had in a secondary home as an investment vehicle hoping that it would appreciate over the next ten years and they'd have some profit after selling it. They bought this property for $100K in late 2007 just before the financial crash. Given the market situation after the crash and the slow recovery, in 2017 the property is still worth only $50k or about half of what they each paid for their property. But, what if Jane had rented the property for $500 per month while Bob did not. Jane had collected about $60,000 in rent ($500/month for 120 months) and technically reduced her cost basis on the property from $100K to $40K. While Bob's still holding on to the property for $100K and hoping that the market will turn around. Of course, Jane's also hoping that the market will turn around so she too can sell the house for profit. But the difference is that Jane's cost basis on the house is just $40K and she'll already sitting on a $10K profit. Having this will help her sleep a lot better at night and will give her the freedom to sell the property a lot earlier than Bob who's currently hoping for a 200% turn in the market for him to break even and sell without a loss (not to mention a lost decade where his money did not appreciate while the cost of living and inflation did).
Now apply this principle to trading. People generally buy a stock and follow the 'buy and hold' approach which means that they'll buy and hold it as long as it takes to make a profit. You may have heard of tales as to how the best performing portfolios are of those who haven't touched their portfolio due to passive investing. Buying something and just hoping for years in hopes that it'll go up is not a likely-to-be profitable strategy, especially when there are options (pardon the pun) to reduce my cost basis so that I can make a profit a lot sooner. Poor Bob might be waiting years for his investment to allow him to rake in some money, while Jane is stress free.
Here's one of my favorite visualization of cost basis reduction courtesy of TastyTrade.com (segment: "Strategies in IRA" dated Jun 21st 2016)
Liquidity measures the ease with which an investor can buy or sell an asset. Think of liquidity in the scope of swimming. The more liquid the water, the easier it is to dive in without getting hurt. However, the less liquid, the less inclined you will be to dip your toes in the water.
By using the most liquid underlyings when trading and investing we can achieve a greater advantage in getting in and out trades. Most liquid tradable underlyings exhibit following characteristics:
Here's some of the most liquid ETFs and stocks with average daily volume (20 days) of over or just about 1 million shares per day:
Eighteen-year old trader, future connoisseur of options.
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