Balanced Trading

[dalentar]

I have some trading buddies that are big on trading a "balanced" portfolio of options. What they do is they want to keep say 4 puts in weak stocks and 4 calls in strong stocks. When they actually have an opinion about the market direction perhaps they will goose one side by adding more puts or calls but generally they are "balanced". When the market goes a direction they profit on the (say the market went down) the puts in this case and lose on the calls. I ask them if they are trading delta-neutral and they say no. I don't completely understand this style of trading. How does one profit from it if you have both calls and puts especially when options tend to fall more than they rise on most moves?

Can someone explain more about this style of trading -- what it's based on and more about how it works?

All thoughts are appreciated.

 

[tomk96]

you explained it. they make bearish bets on weak stocks and bullish bets on stronger ones. if the market moves, they are hoping the weaker ones out perform on the downside and the strong ones outperform on the upside if the market rallies. if the market rallies and they make good picks, they are long deltas from calls while the puts are losers. opposite on the downside.

 

[spindr0]

Quote from dalentar:

I have some trading buddies that are big on trading a "balanced" portfolio of options. What they do is they want to keep say 4 puts in weak stocks and 4 calls in strong stocks. When they actually have an opinion about the market direction perhaps they will goose one side by adding more puts or calls but generally they are "balanced".

It's a variation of pairs trading. The general idea is that strong stocks go up more in an up move and weak stocks go down more in a down move. Shifting their bias is directional. If right, they "goose" the return.


How does one profit from it if you have both calls and puts especially when options tend to fall more than they rise on most moves?

This makes no sense to me. Option price change is determined by a number of variables (delta, implied volatility, underlying price move). Ignoring adverse price change due to decreasing IV and decay from the passage of time, large moves in your direction will result in an increasing delta and that side will gain more than the other side will lose. Option cost is limited. Gain is not.

The short answer is that a system like this will do well if you're finding stocks with large moves and these large moves have to make up for slippage, time decay, possible IV decrease, and the cost of the losing options. It's a lot to overcome.

 

[Eliot Hosewater]

Quote from spindr0:

This makes no sense to me. Option price change is determined by a number of variables (delta, implied volatility, underlying price move). Ignoring adverse price change due to decreasing IV and decay from the passage of time, large moves in your direction will result in an increasing delta and that side will gain more than the other side will lose. Option cost is limited. Gain is not.

I was wondering why they didn't just go long the strong stocks and short the weak ones.

 

[dalentar]

Thanks guys for your replies. It's an interesting topic.
"The short answer is that a system like this will do well if you're finding stocks with large moves and these large moves have to make up for slippage, time decay, possible IV decrease, and the cost of the losing options. It's a lot to overcome."

I've often wondered the same thing myself. Take IV, let's say you want to go long so you need to find a put to go with it. The market has fallen so the puts have had a certain amount of IV added to the premium. My observation is that IV does not come back into an option the way it goes out. It takes a market rise to get the kind of leveraged appreciation you want from options (as IV is pumped into the price) while all it takes is a sideways market to deflate IV from an option. So you're behind the 8-ball at any point in time you want to add to your portfolio. You absolutely have to consider IV. Perhaps they even out when the market decides to move and IV gets sucked over to the other side. The days when the market doesn't move and both the puts and the calls are red really suck. This can eat away at your portfolio until the one big winner or month comes along but how much money are you actually making after all those losers? From what I've seen position sizing is crucial and you always end up losing more than what you set your stop at in the stock. It absolutely depends on letting your winners run and cutting your losers short and having faith that you will catch the next big move to make up for all the losers. I will say though that the leverage is fantastic when you catch it and being balanced can allow you to catch part of a move and then add to positions in the direction the market is moving. Is this your experience?

"long the strong stocks and short the weak ones."

Yes, this is the same idea but with stock. It seems that while you're giving up the leverage of options you're benefitting from lack of decay, IV and so forth. Honestly, I have not done a lot of this style of trading with the stock directly. I should though, soon.

 

[spindr0]

Quote from Eliot Hosewater:

I was wondering why they didn't just go long the strong stocks and short the weak ones.

Because the losses on stock pairs can be significant whereas the losses on puts and calls are limited to the cost of the option.

 

[spindr0]

Quote from dalentar:

Take IV, let's say you want to go long so you need to find a put to go with it. The market has fallen so the puts have had a certain amount of IV added to the premium. My observation is that IV does not come back into an option the way it goes out. It takes a market rise to get the kind of leveraged appreciation you want from options (as IV is pumped into the price) while all it takes is a sideways market to deflate IV from an option. So you're behind the 8-ball at any point in time you want to add to your portfolio. You absolutely have to consider IV. Perhaps they even out when the market decides to move and IV gets sucked over to the other side. The days when the market doesn't move and both the puts and the calls are red really suck. This can eat away at your portfolio until the one big winner or month comes along but how much money are you actually making after all those losers? From what I've seen position sizing is crucial and you always end up losing more than what you set your stop at in the stock. It absolutely depends on letting your winners run and cutting your losers short and having faith that you will catch the next big move to make up for all the losers. I will say though that the leverage is fantastic when you catch it and being balanced can allow you to catch part of a move and then add to positions in the direction the market is moving. Is this your experience?

Yes, this is the same idea but with stock. It seems that while you're giving up the leverage of options you're benefitting from lack of decay, IV and so forth. Honestly, I have not done a lot of this style of trading with the stock directly. I should though, soon.

Like margin, IV is a double edged sword. It hurts long option positions when it decreases. It helps long option positions when it increases.

AFAIK, outside of IV expansion due to earnings announcements, IV would be a secondary consideration with option pairs. Large UL price movement would be a goal and a necessity.

Apart from the aforementioned disadvantages of options, their big advantage is that unlike stock pairs, the losses on any losing option would be limited to the cost of the option.