Building a Diversified, Low-Cost, High-Performance ETF Portfolio

In this article you will learn how to build a diversified portfolio of multiple asset classes without having to pay a manager

The stock indexes including the S&P 500 and the Dow Jones Industrial Average have been rising in 2009 but does this mean investors should be all in stock? According to the most recent ‘Survey of Consumer Finances’ that is what almost all investors have done, however, a few exceptions to that trend.

The top 10% wealthiest Americans have continued to own stock but have also increased their holdings in bonds and income investments. The other 90% have moved out of bonds so completely it no longer registers on the survey. Is one population better off for the choices they have made to diversify or concentrate?

Video: Part One of Building a Diversified Portfolio

What adds more interest to this phenomenon is that over the recent survey period the top 10% wealthiest investors have seen an increase of 100% to their portfolios prior to the most recent crash.

The gains for the other 90% were barely a third of that. This is not a coincidence. Despite the marketing hype and the excitement around the earnings-game there is a reason to be invested in more than just stocks.

Asset allocation and portfolio management are difficult subjects for many investors. This is due in equal parts to the fact that there is a lack of consensus among professionals as to the best way to approach these problems and the issues can be complicated.

These complications can be both cognitive (asset allocation requires a learning process) and emotional (greed often conspires against rational investing). However, there are ways to both simplify the issues and to make it achievable for even very small investors to begin understanding and applying the key concepts behind portfolio management.

In this article series I will introduce the basic concepts of asset allocation through a three step process. You will learn these basic principles.

1. Determining allocation percentages
2. Investing in individual securities (stocks, bonds, futures, etc.) or funds (mutual funds or ETFs)
3. Making adjustments and rebalancing a portfolio

Lets start with determining allocation percentages. Most investment professionals will agree that a blend of asset classes within your portfolio is a good thing but how large those allocations are is a much more cloudy issue. There are basically two factors that you have to consider when deciding on your own allocation strategy.

– How much of a bear market burden can you handle
– What kind of future returns do you want

These two factors are difficult to reconcile. Higher return assets like stocks are often accompanied by very large and unexpected corrections to the downside leading to a large bear market burden. While investment grade and government bonds have a great deal of capital protection they offer low long term returns.

Here is a good example of how two hypothetical allocations acted during different market conditions.

1. An 80/20% mix of stocks to bonds lost -34% in the bear market of 2000-20002 and lost -54% in the bear market of 2008-2009 (so far)
2. A 20/80% mix of stocks to bonds gained 7% in the bear market of 2000-2002 and gained 14% in the bear market of 2008-2009 (so far)

When looked at during these periods the bear market burden seems to bias investors towards a more conservative bond portfolio. However, over longer periods of time that include bull markets, the higher risk portfolio will outperform the lower risk portfolio including inflation by a ratio of 2:1. Finding the right mix for you is the real challenge within asset allocation.

In the video above, I look at how to start solving this problem so that you can refine your allocation yourself. You will learn thatn there are more than two asset classes to choose from, and the more uncorrelated asset classes you include the better your diversification will be. You will also learn why considering your age and retirement horizon will give you some insight into how heavily you invest in riskier assets like equities. I will start this video series by creating a fairly general asset allocation strategy that we can refine as we progress.

Part 2: Investing across asset classes is as important as diversifying within an asset class

Asset allocation does not have to be complicated. Current market products and cost structures make self-management and asset class diversification more achievable than ever before. In part two of this article I will walk through the decision-process between utilizing individual securities to achieve asset class diversification or ETFs and indexed mutual funds.

You will find that while both options are perfectly reasonable, small investors often lean towards ETFs and funds, and in the video I will explain why.

Video: Part Two of Building a Diversified Portfolio

Diversification is a multi-layered issue. There is horizontal diversification across asset classes and another layer of vertical diversification within each asset class. For example, investing in just a single stock will not optimize the benefits of diversification in the same way investing in 12-40 stocks will. Within each asset class you will have to spread your risk across more than one security and this can be difficult for small investors.

Doing this one stock at a time has one major disadvantage – costs. Buying 12-40 individual stocks is certainly possible but commission costs may become prohibitive. For small traders this issue is exacerbated because commissions, which are usually fixed, are a larger percentage of the total investment.

Alternatively, a low cost ETF or indexed mutual fund can provide exposure to many stocks within a single investment and only one commission needs to be paid. In fact, it is possible for an individual investor to use indexed mutual funds to execute a portfolio strategy like we have described and potentially pay no commissions.

The other issue that investors will need to deal with is access. For example, in the portfolio I have constructing within this article series I included commodities as one of the asset classes to increase its diversification, however, when investors think about commodities they think about the futures market. Investing in futures requires a futures margin account, which comes with its own costs and margin requirements that may be prohibitive to small and mid-size investors.

Fortunately investing in commodities, bonds, stocks and real estate can all be done through ETFs or indexed mutual funds. This reduces trading costs, increases sizing flexibility and makes it possible for individual investors to access several asset classes within a single account.

ETFs and indexed mutual funds always come with some costs but these are usually much more reasonable when compared to the convenience and benefits. They are also usually much less expensive that traditional managed funds. In the game of investing, controlling costs is a major priority.

Part 3: Learn how and when to rebalance a diversified portfolio.

With modern financial products even small investors can diversify across several asset classes. However, once achieved do these allocations need to be adjusted? If adjustments are needed how and when is that done? This part of the article will answer those questions.

Video: Part Three of Building a Diversified Portfolio

Some of the most important things to remember from this series of articles is that successful portfolio management relies on simplified processes and low costs. In the last section that meant that most individual investors should have a bias towards funds and ETFs. In this article the same principle applies to keeping allocation adjustments to a minimum.

Adjusting allocations within your portfolio carelessly is a great way to increase trading costs and may lead to over trading. However, some adjustments are usually necessary once asset values have drifted away from the percentage allocations you originally setup.

There are two general ways to approach adjustments. Some traders will reallocate or rebalance their portfolios tactically while others will adjust more passively.

Tactical Reallocation:
Imagine that you have spread your investments evenly across 5 asset classes including stocks and bonds. Assume that a year from now stocks have performed very well and have risen from 20% of your portfolio to 30% while bonds have dropped from 20% to 10%.

A tactical manager may decide that stocks are likely to continue doing well and that even more money should be reallocated to that class. At the same time a tactical manager may decide to reduce their exposure to commodities that that they have decided will become more risky in the near term.

The new asset allocation structure for a tactical manager is based on forecasts and analysis and may continue to change in the future. Often this kind of management is often called “market timing.”

Passive Reallocation:
As a passive manager you are more interested in trying to maintain your desired exposure levels across asset classes than forecasting the future. That means that in the example above you may wish to increase your exposure to bonds while reducing the stocks component to bring the original allocation back to desired levels.

Passive managers typically reallocate based on a calendar date (every 6 or 12 months for example) or based on investing objectives. A passive manager may reallocate assets if their lifestyle or objectives change or on a regularly scheduled plan. This keeps things very simple and prevents over trading.

The principles presented here are not complicated but they can be very powerful over the long term. They can help reduce major portfolio shocks while producing significant returns. From here we will begin working through the practical issues of asset class diversification. You will learn more about how to decide what percentages are appropriate for you, how to find individual investment ideas and what brokerage services are needed.

Part 4: Diversification is easier than you thought and you can do it without a manager

In the first and second sections of this article I glossed over the percentage allocation problem with a fairly generic allocation of 20% per asset class across 5 classes. If you take a closer look, you will see that the portfolio was evenly allocated across risk categories as well. There are a lot of complicated ways to allocate assets and for determining how they should change over time, but it really doesn’t have to be more complicated than that.

Video: Part Four of Building a Diversified Portfolio

For example, a classic rule of thumb is to allocate the same percentage of your assets as your age to conservative investments like bonds and the remainder to riskier assets like stocks. If you are 35 now that means you should have 35% in bonds and the rest in stocks. Similarly, once you reach age 65, you should have 65% in bonds and the rest in stocks.

However, if you think about this strategy for a minute you will find that over those years you were, on average, allocating 50% to bonds and 50% to stocks. You could accomplish the same objective without a lot of age-based rebalancing by just allocating this way in the first place and then remaining consistently balanced.

The point behind this example is to show that you don’t need to get too fancy with your allocation strategy. Find a balance that suits your risk tolerance and stick with it. If your life style changes and your risk tolerance changes with it – then make changes. Over thinking the portfolio percentages problem doesn’t ultimately do very much for you.

Finding Investments
In this series we emphasized the benefits of ETFs or indexed mutual funds as a very low cost alternative to individual securities, futures and bonds. However, this still leaves a pretty large pool of choices available.

Broker Issues
This is where many traders make mistakes. Some brokers specialize in attracting the active investor and may penalize low activity accounts with fees or low/no interest payments on cash reserve balances. Alternatively, many brokers specializing in longer term accounts may charge large commissions up front.

Take some time when evaluating your broker or potential brokers by asking them to quote commissions, fees and interest on cash balances based on your portfolio strategy rather than based on their published rates. Published broker rates can be very biased and difficult to understand within the context of your portfolio needs.

There is an investing adage that says; “your life should be interesting and your investing should be boring.” To a certain extent we feel that is true although we think “boring” should be replaced with “simple.” Modern financial products like ETFs and online brokers have put the tools of the professional in the hands of the consumer investor. Get a little education and you can be on your way to becoming a successful portfolio manager.

Part 5: How to use strategic diversification to increase your profitability

In this article we have discussed a simple but effective way to build a portfolio of diversified assets across different classes and instruments. If you want to stop there that is fine and you could easily become a very effective investment manager.

Or you can move on from here and start learning how to implement investing strategies designed to continue reducing account volatility and increase profits. This article will introduce you to the topic of strategic diversification and give you a starting place to begin learning about options strategies.

Video: Part Five of Building a Diversified Portfolio

Diversification is the only free lunch in the market because it comes with benefits and no disadvantages. However, many traders have no idea what diversification actually is or how to maximize its benefits.

As we have discussed in this series, there is more to a diversified portfolio than just a large pool of stocks, and I think it is easiest to think about diversification in three layers;

1. Horizontal Diversification spreads investment capital across several asset classes. An investor using horizontal diversification may have market exposure to stocks, bonds, currencies, treasuries or other asset classes at the same time. Within each of those asset classes, a prudent investor could use vertical diversification to maximize their benefits.

2. Vertical Diversification is what you are doing when you invest money allocated to the stocks asset class across several industry groups or within an indexed ETFs like SPY, IWM or DIA. This helps limit your exposure to unknown disruptions within individual stocks.

3. Strategic Diversification is a way to think about using more than just “long” positions to invest in the market. For example, option investors will sell calls against a long position to reduce account volatility. Stock traders using this strategy call it a “covered call.”

Over the long term, reducing volatility in this way can be shown to increase returns and reduce risk, but this is just an example starting place when beginning to diversify across strategies.

Strategic diversification is the answer to “what’s next?” when thinking about building a diversified portfolio. Many traders start with covered calls and similar strategies and begin building on that knowledge to create a management plan that improves their ability to achieve better returns with less risk than they could have otherwise. Learning Markets exists to help you understand the strategic options available and to help you implement them.

How to Use Option Collars to Protect Your Stock

Selling covered calls against a long stock or ETF position is a great way to hedge risk and smooth volatility. Selling a covered call on the S&P 500 on a monthly basis has been shown to not only reduce volatility but to increase returns over the long term. However, considering current market conditions many investors are looking for even more downside protection against market downturns.

Trading a covered call / protective put combination can be a great way to harvest many of the benefits of a covered call while maintaining fixed risk to the downside. This strategy combines two of the most common uses for options, both of which are focused on protecting against losses while still providing an opportunity for profits.

[VIDEO] How to Use Option Collars to Protect Your Stock

The strategy is relatively simple. In the video I will walk through a case study using the Russell 2000 ETF (IWM) by selling an at the money call against a long position in IWM (the covered call) and buying an out of the money put (the protective put) to limit losses. The short call will provide a premium for potential profits and the protective put limits the risk in the position.

Assume that you were interested in dipping back into the market following the March 2009 rally. IWM looks like an interesting opportunity but is at a potential resistance level and stepping in at this point with an outright long position may be too risky. To improve the risk profile of this position you could sell an at the money covered call and then buy an out of the money put – both with April expirations.

In the video the prices I used were as follows.

IWM: $41.39
April 41 call: $2.22 Premium received
April 39 put: $1.10 Price paid

The long put has reduced the premium received from the call to $1.12 per share or $112 per contract. The offsetting benefit of this reduction is that there is now a maximum loss of $1.27 a share no matter how far the stock drops. For this case study imagine three potential outcomes at expiration in April.

1. The stock rises to $43 per share.
The stock will be “called out” at $41 creating a $.37 loss offset by the $1.12 per share net option premium for a gain of $.73 per share or 2%. This is the maximum gain that month.

2. The stock stays flat at $41.39 per share.
The stock will still be called out at $41 creating a $.37 loss offset by the $1.12 per share net option premium for a gain of $.73 per share or 2%. This is the maximum gain for April and the results look identical to scenario #1.

3. The stock falls to $35 per share.
The stock falls to $35 creating a loss of $6.39 per share which is offset by the put (which is now worth $4.00) and the net option premium of $1.12 per share. This has limited the actual loss to $1.27, which is the maximum possible loss that month. The benefit of this strategy is that losses won’t exceed the maximum of $1.27 if the market moves against your forecast.

Keep in mind that in any of the three potential outcomes you can reenter the trade the next month and every month after that should you choose to do so. As market events unfold you may choose to loosen the risk control to allow for more upside potential. This kind of strategy is extremely flexible and allows you to adjust it for your own risk tolerance.

Trading Covered Calls

Option traders frequently start their trading career as options buyers. That can be a great strategy when executed properly but time value works against you. When you are an option buyer, you have to be right about market direction and about the amount of time it will take the market to move. But did you know that it is possible to be on the other side of the trade as well?

[VIDEO] Trading Covered Calls: Part 1

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An options writer sells, or “writes” the option contract that option buyers are paying for. By creating the option, the option seller is taking on the opposite responsibilities of the option buyer. If the option buyer wants to “exercise” their option, you as the seller will need to deliver on the contract. That gives the writer an obligation to deliver.

For example, imagine you want to sell a call. The transaction is relatively simple. You would anticipate being paid the bid price or “premium” for the sale and now you have the obligation to deliver the stock if the option buyer exercises his option.

There are some distinct benefits of selling options:

  1. You get paid your potential profits up front in the form of the option’s price or premium.
  2. If the option expires out of the money, which most options do, then no one will want to exercise the contract and you will keep your entire premium.
  3. As time value melts, the decline in the option’s value reduces your liability and risk as the options seller. Because you already sold the option for a high price and took the premium, you can later buy it back for a cheaper price as time value melts, allowing you to exit the trade any time you like.
  4. You can close your trade at any time. All you need to do is to remove the obligation by buying the option back and washing out the trade. This can be done on the open market at any time.

There is, however, risk with selling options that needs to be controlled. If you sell a call, you have the responsibility to deliver the underlying stock if prices rise and the option is exercised. You can see this graphically in the chart below.

If you had sold a call in April on Google (GOOG) below, with a strike price of $450 per share and the stock gapped up (like it did later in the month, to $550), you are still responsible to deliver the stock to the options buyer for $450. That means you will lose $100 per share as you buy the stock on the open market for $550 to deliver it to your options buyer for $450.

GOOG April Call Example
GOOG April Call Example

The good news is that this risk can be controlled, and is partially offset by the premium you were initially paid. Once they are netted out, these losses may not be as much as you think. I am using an extreme example of a large gap to make the point that options selling does not need to be scary. In the video above we will look at how this trade worked out.

Covered Calls Strategy

In this section of this lesson we will discuss the covered calls strategy, to illustrate how you can further protect yourself from these disadvantages while still retaining the benefits of being an option writer.

The core principle of writing covered calls is that you are controlling risk and attempting to improve returns on a stock or ETF that you own. You can do this by selling a call option against that stock or ETF and collecting the option premium. A covered call consists of a two step process that is easy to implement by new and experienced investors alike.

[VIDEO] Trading Covered Calls: Part 2

The first step in writing a covered call is to be long the underlying stock or ETF. Sometimes investors are selling a covered call against a stock they may have owned for a long time and other times an investor may be buying the stock and selling the call option at the same time, which is sometimes called a “buy-write.”

The second step in writing a covered call is to sell a call against that long stock or ETF position. There are several factors to consider when you are selling the call including, expiration date, strike price and premium. Let’s walk through a case-study of a covered call to begin answering these questions.

Imagine you own 500 shares of Apple (AAPL) and you want to sell 5 call contracts to make some income from those option’s premiums. That trade is a covered call.

The covered call is “covered” because you already own the stock. If prices rise and the call buyer wants to purchase the stock, you have the ability to fulfill on the contract without going to the open market because you already own the stock. This alleviates the problems with selling a call alone as discussed in part one of this series.

Let’s assume you had owned 500 shares of AAPL in late March 2008 when the stock was priced at $140 and sold a call against it with a strike price of $145 and a premium of $6.00 per share or $600 per contract.

As the seller, you were paid $600 of premium per contract for 5 contracts of AAPL calls you sold, for a total of $3,000. That sounds good so far – you made three grand.

However, let’s now look at what happened to those options you sold at expiration, when that obligation to deliver the stock was due.

By April’s expiration the stock was priced at $155 per share and the call buyer wants the stock. She has the right to buy it for the strike price of the calls, or $145, as detailed above you already own it and your broker would just take it out of your account automatically.

You bought the shares of AAPL for $140, so by selling it for $145, you made an additional $5 per share, or $2,500, plus you keep the premium for the calls of $3,000. A good profit, but the downside of the option is that by selling the right to buy at the $145 strike price, you missed out on another $10 per share on the rise in the price of the underlying stock.

The advantage of owning the stock was that is protected you from the liability created by the big breakout in April. Otherwise you would have been responsible for acquiring the stock on the open market for $155, which you would have had to sell for the $145 strike price. The difference is substantial, in that the covered call was a profitable trade, whereas just writing a call without owning the stock would have resulted in a loss.

The advantage of selling the call is not as evident when the market is rising but really comes into play when prices drop. Selling the call and earning the premium provided $3 per share of protection against losses. This protection has the effect of reducing account volatility and improving returns. Over the long run the reduction in losses is well worth the opportunity cost of losing a little upside potential.

AAPL Call Example
AAPL Call Example

In the video above I will look at this situation in more detail and contrast it with other scenarios like when the stock’s value goes down. Covered calls are not only a great way to limit your liability as an option writer but they are an excellent way to hedge risk on your stock holdings as well.

Final Concepts to Keep in Mind

Covered calls, when applied consistently over the long term, deliver significantly lower account volatility without decreasing profit potential. In fact, long term covered call indexes show that account volatility is reduced and returns are increased. A covered call is one of the very few ways to accomplish these two objectives at the same time and is a gateway to learning more about using options as an investor.

[VIDEO] Trading Covered Calls: Part 3

As we discussed earlier in this article, during short-term rallies a covered call can sometimes cap profit potential on the underlying stock. This happens because you can only make the premium you were paid when you sold the option plus the strike price for the stock itself. If the stock is running away to the upside you may have made more just holding the stock.

However, if the market breaks to the downside, the option will expire worthless and you get to keep the entire premium because you will not have to sell the stock at expiration. That premium offsets some or all of the losses you might have accumulated on the underlying stock when it dropped.

Over the long term the reduction in losses more than offsets the opportunity cost of limited gains when the market really takes off.

When you net out the affects of capped gains and hedged losses with covered calls, the end result is a strategy that can reduce the ups and downs of your portfolio but still deliver great returns. In the video, we will look at a classic illustration of this concept that can be monitored in the market every day.

There are a few final concepts to keep in mind as you become a covered call investor.

  1. Be careful about commissions if you buy the stock and sell the call at the same time, this trade is called a buy-write. Call your broker and talk to them about this order type and any restrictions or additional costs they may have.
  2. Covered calls require the lowest level of options trading approval from your broker. Call and make sure this is something you have permission to do in your account.
  3. You can exit a covered call at anytime. If you want to get out, all you need to do is buy the call back at the current ask price and sell the stock.
  4. Many traders will choose to exit a call that has moved in the money that could be exercised at expiration to avoid having to sell the stock they own in their account. There is nothing wrong with this; it is really up to you. It can avoid the hassle and transaction costs of clearing the underlying stock, especially since you’ll often write calls on the same stock over and over.
  5. There are a lot of options writing and covered call “advisory services” promising huge returns. These are seldom true and may come with big fees and lots of account volatility. If you see promises or examples of huge monthly returns from covered calls, be careful; you are probably not getting the whole story.

Covered Calls the EZ Way

In the current market environment, volatility is very high and most traders are spending as much time on risk control as on any other activity. This is appropriate but there can be some challenges in that, especially for smaller traders.

Video Analysis: Covered Calls the E-Z Way

For example, one of the most popular options strategies for retail investors are covered calls but they typically require you to buy at least 100 shares of stock to sell a single call contract. This is because a single call contract represents 100 shares of stock.

If you were selling covered calls against the SPY (S&P 500) ETF you could be out $9,000 or more for 100 shares. That may be out of reach for smaller traders. You can learn more about how a covered call works here.

There are solutions to this problem that preserve the benefits of selling a covered call without requiring a large capital investment. The same company that lists the popular QQQQ (Nasdaq) ETF also lists the S&P 500 buy-write (PBP) ETF.

This ETF replicates the results of selling covered calls each month on the SPY but is only $18 per share and can be purchased as a single share or several thousand shares depending on your capital and needs. This allows smaller traders to harvest the benefits of a covered call without the minimum capital requirements.

Investing with covered calls has been shown to provide the same long term growth potential over the long term in a diversified stock index but reduces volatility. Reducing volatility means that you are risking less for similar returns.

This is usually what traders are talking about when they say thier strategy is generating “alpha” or excess returns. In the video I will walk through an example of how a covered call strategy like PBP compares to simply investing in a stock index.

Increasing Profits with Covered Calls on LEAPS

Covered calls are a great strategy for reducing account volatility and earning income on your long stock positions. On the Learning Markets website We have also talked about using LEAPS options as a way to “lease” stocks for less money than it costs to acquire the stock outright.

Is there a way to combine the benefits of these two investing strategies to get the best of both worlds? Yes there is by selling covered calls against a long LEAPS option position, also known as diagonal spreads.

Here are a few of the key concepts to keep in mind when trading a covered call on a LEAPS option:

Risks

1. You are short a call without an underlying stock position. This means that if you are “called out” you could find yourself short the stock.

2. A LEAPS option has time value that is melting each day as you near expiration.

3. Option trades are often at a higher commission rate and this will increase your trading costs.

The benefits of trading a covered call on a LEAPS option are also very significant. I have outlined a few of those in the list below:

Benefits

1. The LEAPS contract is cheaper than the underlying stock and that increases your leverage and potential profits

2. Because the LEAPS contract is cheaper you have less risk in absolute dollar terms than holding the underlying stock

3. This is a strategy that can be used with index options as well as stocks and ETFs

4. Using it on index options with European style expiration eliminates the slight possibility of early exercise

Balance the risks and benefits to decide whether this strategy works for you and to help you decide the best way to implement it within your portfolio. As we release this series of articles I will use a case study to illustrate the concepts. Repeat the steps in the case study on an option of your choice in a paper trade. Repeating the method yourself will help you understand the strategy and remember how it works.

 

Part Two – Steps for entering a diagonal spread trade.

In the second part of this article on selling covered calls against LEAPS or diagonal spreads I will begin walking through the entry process with a case study. The numbers and real life scenario should help you understand how these trades work and why they are attractive but if you really want to remember the information you should paper trade it a few times yourself. Going through the process by hand will help you remember the process.

In the case study I will use an index option with European style expiration. This solves the problem of early exercise that I mentioned in the first part above. Because European style options can only be exercised at expiration and not before. The index option I will use is the Mini SPX Index Option (XPS.) The XPS or mini version of the SPX is good for smaller traders as the options are only 1/10 the price of the normal SPX options.

Step 1: Buy the long term option

First, we need to buy the long term option at least a year out before expiration. In the case study this means buying the December 2009 calls.

The long term options purchased can be very far in the money if you wish, but I typically suggest buying one strike price in the money. Assuming a current XSP price of $93 that means I would buy the $90 strike price calls for $1,615 per contract.

Step 2: Selling the short term option

In my experience, buying a far in the money long term call does not materially impact returns compared to a call that is very near to the at the money strike price.

What is important however, is that in the next step you sell a short term call with a strike price ABOVE or further out of the money than the call you bought. In this case, that means I would sell the December 2008 95 strike price calls for $535 per contract. The rate of return just based on those prices is more than 30%. Of course, risk and time value will eat away at that best case scenario.

At this point the trade looks very similar to a covered call. The long term option takes the place of the long stock and protects against the unlimited losses that may occur with a short option alone. In the next section I will cover what happens if you are “called out” of a trade like this at expiration.

 

Part Three – How to deal with expiration when trading diagonal spreads.

Diagonal spreads can lead to interesting problems at expiration if the short call is in the money. There are a three concepts you should be aware of when dealing with an in the money short call and this article will discuss these concepts and their affects on the case study used in the video. Keep in mind that like a true covered call, if the short option expires out of the money there are no additional actions needed, but you will get to keep the entire premium.

American Style Stock Options:

Most options on stocks and ETFs are American style expiration which means that if your short call is in the money it can be exercised at any time. Although early exercise is rare it does happen.

If the option is in the money at expiration it will most likely be exercised. Because you don’t actually own the stock when you are exercised your broker will probably short the stock in your account. If you are not prepared for this you should avoid selling or writing American style options.

European Style Index Option:

In this series we used an European style index option on the XPS. This style of execution means that you cannot be exercised early.

If the option is in the money you may need to take some action by expiration but you don’t need to take action before that time. If you do not want to be exercised at expiration you will need to buy the option back at its current market price before expiration.

Cash Settlement:

Most European style index options like the SPX or XSP are cash settled. That means that if at expiration the option has a value of $100 you will have $100 withdrawn from your account to pay for the “exercise.” If you had been long that option when it expired you would have had the $100 deposited in your account.

These options are cash settled because there is no underlying stock. They represent an index rather than a real stock and therefore you don’t have a potential short stock position like you might with an American Style option.

In the next section we will talk about what happens if the market declines. This is good for the short call position because it is more likely to expire out of the money and you get to keep the entire premium. However, there will be losses on the long term call. We will cover when you should consider exiting the entire position and reenter after a larger drop in the underlying stock or the index.

Part Four – How to make adjustments to your spread when the market does not go your way

One of the most significant benefits of covered calls or diagonal spreads is the hedged position it creates. The premium from the short call offsets some or all of the losses on the long call with the further expiration if prices drop. I am convinced that managing risk as a trader is one of the most important things we can do, which makes diagonal spreads or covered calls on LEAPS a very attractive strategy.

The risk management within this trade can help to put you one step ahead of market volatility. In the video I will go over what happens to this trade when prices drop, which may not be the worst result. If the short call expires out of the money you will keep the entire premium and owe nothing. However, the long call will have sustained losses. It may become necessary to sell the long call and reconstruct the trade with a new in the money long term option or LEAPS call before you sell another call in the short term.

How to Position Size an Option Trade

What you really have at risk in a specific option trade is often a function of whether you are long or short, and how quickly you think you can get out of a bad trade. For example, a long option’s risk is limited to the premium or purchase price. However, a short option has theoretically unlimited risk since the market may move up or down infinitely.

That means that your maximum loss may be just the option premium in the case of a long option, or your stop loss in the case of a short option or long stock position. Once you know what your maximum risk is, you can determine your position’s size. You can determine the size of a position by dividing that maximum risk amount into the total amount of your portfolio you have set aside for an option trade.

For example, if you assume that you are willing to use $10,000 of your portfolio for options trades and you are willing to risk 5% of that amount on any single trade then you are willing to lose $500 in a bad trade. Therefore, if you are evaluating a long call or put position with a max loss of $250 per contract, you could buy two contracts. This is not a complicated calculation, which is the way it should be. The easier it is to stay consistent the more likely it is that you will be able to accomplish your primary trading objectives.

In the video I will look at the process of determining a position size for two option trades trades. In the first example I will evaluate an outright long option position, and in the second example I will walk through a covered call. The second example is slightly more complex becuase it includes a long stock position with a short call combined into a single trade.

The most important principle to take away from this discussion on position sizing is consistency. If you are trading without a set position sizing plan, you will be inconsistent and that will introduce additional volatility into your account, which will create losses. This is one of the most common problems new option traders deal with, but it is also one of the easiest issues to solve.