Last month, on June 1, 2016, in a tasty BITES segment called "Uncorrelated Trading" we discussed the importance of true diversification in the underlyings in all accounts, but especially in tastyBITE sized accounts. True diversification of underlyings means low correlations. It doesn’t matter if you have a dozen different stocks if they generally act similarly. Is there another way traders could be diversifying their portfolio?
As a reminder, a graphic of correlation was displayed. The graphic showed the spectrum from a negative correlation (-1.00) to a positive correlation (1.00). A correlation of zero corresponds to no relationship between the underlyings. Tom and Tony noted, “This is true diversification, in a perfect world we’d be wrapped around zero (correlation)”. A table displayed the results of selling Strangles in two underlyings with a high correlation, GDX (Gold Miners ETF) and SLV (Silver ETF) versus selling Strangles in GDX and IWM (Russell 2000 ETF) which have almost no correlation. The results for the latter pair were clearly better.
The Market Measures from May 31, 2016: “Strategy Diversification” demonstrated the importance of a diversification in strategy for all traders. It’s even more important in a tastyBITE account in which the margin for error is smaller. A table comparing the correlation of strategies was displayed. The strategies included a Straddle, Strangle, short Call Spread and an at-the-money (ATM) short Put. Straddles and Strangles are highly correlated strategies. The short Call Spread and short ATM Put have a relatively high negative correlation. The table showed a ZERO correlation between a Stangle and a Call Spread. Another table demonstrated how to reduce correlation to outsized moves in the XLF (Financial ETF). The table showed how by trading a Strangle and a Call Spread in XLF reduced your P/L variance (risk) dramatically as compared to trading a Straddle and a Strangle in the XLF. Tom and Tony noted that nobody knows where the market is going to be. All you can do is set yourself up for success by reducing your risk by using these uncorrelated strategies.
Watch this segment of tasty BITES with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of how diversification in your portfolio and the strategies you use will reduce your overall risk.
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