Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
Diversification is a fundamental concept in managing investments.
Put plainly, it means you don’t have all your eggs in one basket. In theory, when you own a variety of uncorrelated stocks and asset classes (bonds, commodities, foreign currencies, etc.), you reduce the volatility of your portfolio.
The idea is that if one area takes drops, it will be offset by the rise in another.
The overall value of your portfolio doesn’t fluctuate much.
It’s a risk management strategy to prevent overexposure to one index or sector. If the DOW and S&P500 get hammered, you won’t find yourself underwater.
But does this principle apply to your options portfolio as well?
A tough question.
If you ask a hundred traders, you’ll get a hundred answers. Some strive for complete neutrality to market direction and diversify tickers as much as possible.
However, that’s not my style at all.
This comes from experience. Managing market-neutral and diversified portfolios takes an exceptional amount of mental energy.
It’s often overwhelming for professional traders, so I steer new traders down a different road – directional bias and concentration.
As author Werner Erhard famously said:
“Ride the horse in the direction it’s going.”
Learn to read the market and sector trends, then follow them.
We’ve spoken about this before. It pays to be bullish in bull markets and bearish during downtrends.
Don’t spread your capital all over the map – learn how to read charts, create watchlists, and focus on the rising sectors.
Follow these simple steps, and you’ll be on the right track.
First, understand the general market condition by analyzing the major indexes.
Is it trending upwards, sideways, or down?
Does it look set to continue its current trajectory, or are there signs of an impending pullback?
Second, identify the sectors, subsectors, and asset classes in the market that are rising. Money rotates through sectors – something is always moving up.
Which are the strongest and which are the weakest?
What index ETFs can you trade to capitalize on these trends?
Finally, if you prefer to trade stocks instead of indexes, look at the components within those uptrending sectors for opportunities.
Which are the top performers and which are the weakest?
What trades will maximize your profit potential on these underlying stocks?
When trading options, emphasize the large-cap stocks. Get acquainted with the highly liquid behemoths of the market jungle such as GOOGL, AMZN, MSFT, and ADBE.
Maintain carefully selected watchlists and set your alerts for your entry triggers.
Let momentum shifts, pullbacks, EMA crossovers, or whichever technical indicators you use guide you.
If you’ve found a solid underlying and your pilot trade is working, then add positions so you can milk all the profits you can while it’s running.
This is what I call a FOCUS TRADE – the exact opposite of portfolio diversification.
When a trade is working, add to it.
There’s nothing wrong with having long calls, bull call spreads, bull put spreads, and butterflies all on the same stock.
Reduce risk using a mix of expiration dates and trade types.
Make profits on each slight upswing, add credit spreads or cheap calls on pullbacks, and take advantage of the fact that you were correct about the underlying.
No need to go searching for random stocks just to “balance out” your portfolio.
If you trade ETF’s, there’s actually a certain amount of built-in diversification. Each provides exposure to several related equities.
Sector and index ETFs don’t usually go parabolic like stocks. Still, it’s the slow grinding profits that keep your account growing in the long term.
So there’s your plan.
Save yourself from endless scanning and free up your mental capital.
Concentrate, focus, and win.