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
A basic article on correlation
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?
amber tree leaves 
tI don’t pay attention to correlation as I find diversification in general to be overrated.
As Warren Bufett said: ‘Diversification is protection against ignorance. It makes little sense if you know what you are doing’
http://www.investopedia.com/ask/answers/031115/what-did-warren-buffett-mean-when-he-said-diversification-protection-against-ignorance-it-makes.asp
Find good companies with a wide moat and pricing power and you will do well. Writing puts is to lower my price to buy the stock (or to just have the premium if cash is low) and writing covered calls is to sell the stock if the price is getting too high for my taste (or to generate a little bit of cash flow from a non-dividend stock since dividends are taxed and option premiums are not).
It makes life so much simpler but it does have the consequence that in a market crash your portfolio can go down, a lot! But if you selected your companies correctly they should bounce back nicely after the crash. You just have to have the stomach for those (luckily rare) drops.
The thing is, with now being invested in Berkshire I am actually diversified since it is a big diversified holding. And I am also in a perfect position to profit of a market drop since he will then be able to deploy all that cash to buy up cheap stock! Being lazy does have its advantages…
The leveraged construction and my options are just because I get bored and I want to add a few percent points to the return Berkshire will give me. But the main and hardest work will be done by Buffett. What’s that? Do I feel any guild about me, a 42 year old, outsourcing the hardest work to a 84 year old man? Nope …
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Overrated, maybe… I do follow your thinking… I guess I can not stand the thought of having for a few months no option income as my puts are all ITM or assigned and I have to wait for the market to recover for covered calls…
A little effort for a good night of sleep won’t hurt, does it?
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‘A little effort’, this is not the way of the sloth! You have much to learn young grashopper.
A little effort leads to work, and work leads to the dark side!
Remember what Yoda has teached you: do or do not. The way of the sloth is : do not!
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ok, ok, teach me!
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Your opinions on trading are really remarkable, I am going to drive some of my readers to
your web site.
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Have not paid much attention to this, but probably should. I’m aware of the potential risks, that is step 1 I guess. But our overall portfolio is already so diverse, I’m not too worried.
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With the real estate you have, you are probably incorrelated to the stocks you have.
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You might have a point there! Housing prices did follow the crash with a delay, still recovering from the crash in 2008 actually.
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In your case, cash flow might be a better way to compare rather than price.
That being said, when you need cash yourself, you need to sell something or get a private loan.
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Diversification in the same equity will not save or protect you against a systemic risk. Just look at the recent selloff in 2008. When selling, everything is being sold. I have seen people advocating buying gold to protect themselves against a market crash, but in 2008 even gold went down almost 50%. Mutual funds went down, ETFs were crushed, bonds went down. People were selling everything. So no matter how many stocks you own, it will not protect you. The mutual funds own thousands of stocks and yet they were not able to preserve the capital during sell off.
I believe, that in order to protect you need to use totally different asset classes and not just diversify among one class such as stocks. I believe, options, if done right can provide some protection. That’s why I learn and trade options as much as possible to learn navigating the trades though thick and thin days to preserve my capital. The rest is just a matter of time. No correction or sell off takes forever. It will end one day and the stocks will start going up again. As it happened in 2008 up to today.
The other thing is the lost decade (I think it was from 2000 to 2010 or so) where the market went literally nowhere. And that’s when dividends and options income will give you an edge over just holding growth stocks. Combine it with holding and reinvesting in a long haul (compounding profits) and you will become a winner even in a lost decade.
Thanks for posting about diversification and options as that is my favorite topic so many people fail to understand!
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thx for the extensive comment. I a real big selloff, all goes down indeed.
I also see options as a way to generate income in markets that go nowhere.
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I honestly don’t pay too much attention to correlation. It’s definitely something that I think about from time to time but I haven’t purposely created my portfolio in a way that looks at correlation. I usually buy stocks that I think will perform well over a long time and hope that I got a good value on them 🙂
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For DGI and long term investors, this is probably less of an issue.
When I want my options to generate a nice monthly return, then I do think I need to pay attention to this.
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The foundation of your trading strategy is effortless to see.
Many thanks for distributing this to me now.
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Your thinking on trading are impressive, I am going
to throw a number of my followers right onto
your pathway.
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