Diversification is one of the cornerstones to overall investment success and performance of a long-term portfolio. For instance, a well-diversified portfolio should include things like stocks, gold, real estate, bonds and certificates of deposit. While most investors may indeed understand this for their portfolio when they become option traders they seemingly totally ignore this same concept when developing an option strategy trading approach to the markets.
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Just as it is very important for the investor to be diversified in their long-term investments it is equally as important for the options trader to be diversified in the option strategies that they implement.
As option strategists we know that a particular market can go only one of three directions which is sideways, up or down. With that knowledge base intact the option trader needs to deploy option strategies that account for these three scenarios in order to have a diversified options strategy plan of attack.
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First to account for a sideways market the option strategist needs to research and analyze stocks that is currently and has been exhibiting consolidation over the last two to three months. Once a stock or group of stocks have been identified with distinct trading ranges in place make sure they do not have any upcoming news event like earnings or any other catalysts that could cause a breakout in the underlying issue.
Once this is done the options strategist is ready to select the best sideways strategy to put on like a butterfly or calendar spread that takes advantage of the trading range and gradually profits from time decay.
Next to deal with a particular directional bias the option strategist needs to perform due diligence and choose stocks that have a strong bullish or bearish bias based on their technical and fundamental analysis. The option strategist then needs to determine the optimum directional strategy to employ. If possessing a bullish bias the strategist can use straight calls, bull call spreads or bull put spreads. On the other hand if having a bearish bias then the strategist can implement straight puts, bear put spreads or bear call spreads.
Finally, if the option strategist has a neutral outlook they need to locate stocks that are currently experiencing low implied volatility with a key news event like an earnings announcement coming up in the next 2 to 6 weeks. Also, it is best if the stock or stocks have experienced high levels of volatility in the past particularly around a big news event like earnings. Once identified the strategist is ready to choose the best strategy to fit this particular market scenario like straddles, synthetic straddles or strangles.
It is important to note that there are several other combination strategies that can be employed for each market environment which is why it is so important to become familiar with the choices and know for what particular market scenario they will work best. By diversifying among option strategies that address the three environments the option strategist is reducing their overall risk and their account equity curve will be much smoother which in turn will make your option trading business a much more stress free and enjoyable venture.
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Happy Trading!