Instructor

This article will address the importance of diversification among instruments when trading options. Although there can be various types of diversification, including using different option strategies, the  purpose here is to discuss diversification among underlying products.

I found the following e-mail in my mailbox from an Online Trading Academy newsletter subscriber:

Hi Josip,

I just started dabbling with options and don’t know where/how diversification fits in with options. After all, I could just lose what I paid for the options, right?

This e-mail indicates that the student trades only long options, either a long call (+c) or a long put (+p). In such a case his assertion is accurate. However, there is a need for deeper understanding of the market and the products that are being traded if one seriously wants to trade for a living. One of the easiest ways to start building a base of knowledge is to start with the simplest and most fundamental principles: How does the stock market operate? Although I do not intend to spend the rest of this options article on an in-depth explanation, a short one will be provided.

After the discovery of the New World, European countries would set up new colonies with the goal of extracting valuable goods and bringing them back home in order to earn profit. However, bad weather, poor navigation, or even pirates could pose a threat to these enterprises. To offset these possible setbacks the ship-owners would find a number of investors and sell them part ownership (stock) of these enterprises. The new stock owners who helped to finance the voyage’s costs would, when the ships returned, share the profit according to the size of their share holdings. To help increase the chances of success some investors would invest in multiple enterprises, several ships at the same time. In such cases their risk was spread, hoping that at least one ship would safely return providing a pay back greater than their initial investment. The Dutch East India Company took this simple concept to another level by allowing the investors to invest in the entire fleet, minimizing the risk through diversification and it is from there that the whole stock market gradually evolved. The New Amsterdam Exchange is the humble origin of the NYSE.

Similar to the 16 th century Dutch investors, I have “diversification” on three of my option trades. Although diversification has multiple levels, I am still using the archaic & most primitive example in which three uniformly built ships (Iron Condors) are on the same voyage (the same duration). The figure below shows the XEO in a symmetrical triangle going into the July 4 th week. The assumption was made that NOT much price movement would take place during the low volume week and that most likely the weekly bar of that week would still be contained within the triangle, and within the two horizontal lines.

Figure 1: the XEO

The technical situation on the SPX & RUT was very much the same; there were symmetrical triangles on both. Hence, basically the very same Iron Condor trades were placed on all three of them.

Figure 2: the SPX & RUT

The logic behind this is that there would have to be some major “storm” or unusual event that could make all three of these ships sink on the same expedition. Yet before discussing the adventure of the voyage let us address the potential profit that was about to be collected if everything worked out smoothly. The table below, Figure 3, shows the premium that was taken in for each of the three traded vehicles.