For some, the law of large numbers may feel like mo’ money mo’ problems. As stock indices grow increasingly correlated, diversification becomes more challenging. That challenge can be exacerbated in larger accounts.
In 1987, the S&P 500 and the Nasdaq 100 held a correlation of .74. Today, that correlation has increased to .93. We see these strengthening correlations across the board among many of the most liquid ETFs, including international ETFs. It has even led to the rise of the acronym “TINA” - there is no alternative.
Increasing directional correlations means we can no longer invest in different indices and assume a portfolio is diversified. There is a reason merger and acquisition activity has changed over the years with successful companies purchasing businesses in completely uncorrelated markets. Google purchased YouTube. Facebook purchased Oculus Rift. Diversified lines of business offer greater protection. A portfolio should be treated the same.
In addition to correlation risk, passively investing in various index funds comes at a cost. Management fees charged by these funds typically average around 2%. In a $250,000 account, that means $5000 is siphoned away, annually. Not only is a portfolio of various indices not diversified, it also faces drag from fees.
One way we can diversify a portfolio is by using options to reduce cost basis. When cost basis is reduced, so too is risk. There are three primary ways we might use options to reduce cost basis:
Selling at-the-money (ATM) puts
Selling ATM calls against long stock
Selling slightly out-of-the-money (OTM) calls (typically a 30 delta strike price) against long stock
When we use cost reduction strategies, we impose a ceiling on how much money can be made. Take for example, selling a call. If we own stock, sell a call and the stock proceeds to move higher, our stock will be called away. Our gains are capped. However, we are willing to cap gains in exchange for increasing our probabilities of success. That is smart trading.
Buying and holding produces a wide standard deviation of possible returns. Too often, we focus on current market conditions and assume they will last forever. They will not. They never have and never will. Sure, a portfolio long IWM has done very well this year. But what happens when IWM is down for the year? Using options in any of the three strategies outlined above reduces risk and increases returns.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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