A general principle in building a portfolio is to diversification. What does that mean? Just buying a lot of different stock? Maybe there is more. I will also tell you how I add diversification to my option trading.
A basic misunderstanding is that diversification means adding a lot of different stock. I own 50 stock, so I am diversified. It is a little bit more complex: diversification means that you add positions that are not correlated. What does that mean?
The internet is a great source for finding the answer. Today, I want to share some of my sources with you: Tastytrade (no affiliate). At the core, it is an option trading financial network. They also offer great insights in general subjects.
Correlation means that things move together. One goes up the other goes up. Imagine a stock crash. If you have 50 correlated stock, then they all go down… What now?
Here are some great articles on correlation by Tastytrade
With this, I hope that the concept of correlation is now clear. In a portfolio, especially a trading portfolio, you thus need to make sure that you have elements that do not move together. Attention is needed to add elements that do not move together in a stock crash. Especially for options trading, there are multiple ways. Look at the video below (real talk starts at 4:20)
From the 4 ways demonstrated above, I try to apply 2 in my option trading. (2 is better than none)
- I try to have strategies that benefit from a market that goes up or stays flat – selling puts – and strategies that benefit from markets staying flat or going down – selling covered calls. The next step I should take here is to combine both of these in one trade. This is called a straddle or a strangle
- Mix of underlying: In my trading, I stock (blue chip, tech) with oil and gold related stock. In the past, stock, silver- gold and oil have been uncorrelated assets. That means that when one goes down, the others could be up or flat. This way, I try to avoid that my hole portfolio goes against me.
Do you pay attention to correlation when you trade?