How To Determine and Manage Your Portfolio’s Price Risk

How To Determine and Manage Your Portfolio’s Price Risk

We spend a lot of time talking about finding, structuring, entering, and managing individual trades.  But trading is much more than entering and exiting (hopefully profitable) individual trades.  At any one time, you most likely have a portfolio of trades: some bullish, some bearish, some short term, some long term, on a variety of different instruments.  You’ll own options and stocks of companies in different industries with different risks.  Your portfolio will be exposed to price movements, the passage of time and changes in volatility.  Let’s dive into price risk.  Did you know that, based on all your positions, you can determine one number that will provide insight into the price risk of your portfolio at any point in time?  And once you quantify that risk, that there are a variety of steps you can take to manage that exposure?  The key to answering these two important questions is to determine the Beta weighted delta of our portfolio relative to the $SPY.  Let’s walk through how to do that, but first a few definitions.

What is Beta?

In its simplest form, Beta measures the volatility of an individual stock relative to the overall market.  For example, if stock $XYZ has a Beta of 2.0 and the S&P 500 moves up 1.0%, we would expect $XYZ to move up about 2.0%.  If the S&P 500 moves down 1.5%, we would expect $XYZ to move down about 3.0%.  Beta is available on all trading platforms and is determined by analyzing the historical movements of $XYZ relative to the S&P 500.  Higher Beta stocks have greater relative price movement than lower Beta stocks and thus, all other things being equal, have greater price risk.

What is Delta?

Delta has several different definitions but for our purposes it is the price movement of the instrument we own relative to the price movement of the underlying stock or security.  If you own a call option on $XYZ with a .30 delta, and the stock moves up $1.00, you expect your option to increase in price by about $.30.  Alternatively, if you own a put on $XYZ with a -.40 delta and the stock moves up $1.00, you expect your put option to decrease in price by about $.40.  All stock has a delta of 1.0!

What is the Beta Weighted Delta of a Portfolio?

Each position in your portfolio has a Beta associated with the underlying stock and a delta associated with the instruments you hold.  Determining the Beta weighted delta of your portfolio has the effect of converting the price risk of your individual positions into an overall $SPY based delta – an overall portfolio price risk measure. Your trading platform’s portfolio Beta weighting function weights the delta of each position by the size and Beta of the position and then adds across all your positions to determine the total $SPY Beta weighted delta. In other words, what’s the price risk of your portfolio relative to market movements (movements in the $SPY). You’ll have to do a little homework to determine how it works on your platform.

For example, let’s say you have a portfolio of puts, calls, and stocks.  Each option has a different delta, and each underlying equity has a different Beta.  By using your trading platform’s Beta weighting function, you can determine the overall price risk associated with your positions.  Using your platform’s Beta weighting function, you determine that your risk is 250 $SPY deltas – what does this mean? 

How can you use the $SPY Beta Weighted Delta?

You can use your portfolio $SPY weighted delta to determine your price risk.  250 $SPY Beta weighted deltas means that, if the $SPY goes up $1, you make about $250; if the $SPY goes down $1, you lose about $250.  If the $SPY goes up $10, you make about $2,500 and if the $SPY drops $10, you lose about $2,500.  Now that you’ve quantified your price risk relative to overall market movements, how does this risk fit into your risk management plan – are you comfortable with this amount of exposure to potential big market moves?  If not, how can you reduce your risk? Please note, this is not a perfect measure; there are characteristics of an individual stock that may cause it to move out of synch with the market – news, earnings, etc.

How Can You Reduce Your Portfolio Price Risk?

What if you’re more comfortable targeting 200 deltas of risk?  How do you reduce your risk?  The first step in reducing risk is always reducing or closing some positions.  If you want to hold your positions and you have more long exposure than you want, what about buying a few $SPY puts?  How many .25 delta $SPY puts would you have to buy to reduce your risk to your target? You would have to buy two .25 delta $SPY puts – each put controls 100 shares of the $SPY and reduces your risk by 25 deltas (100 shares X .25 delta) so you will need two options to reduce your risk by 50 $SPY deltas.  What if you wanted to use futures to hedge or reduce exposure?  Each /MES futures contract (the S&P 500 micro futures) controls 50 shares of $SPY with a delta of 1 so you would need to short 1 /MES to get to 200 deltas (50 shares X 1 delta).

What Other Factors can Impact Your Portfolio Risk?

There are a few things to keep in mind as you analyze and manage your portfolio price risk.  First, price is only one aspect of your portfolio’s risk – it is also exposed to changes in volatility (Vega) and the passage of time (Theta).  Second, your portfolio price risk is dynamic – your portfolio deltas will change as prices and volatilities change and as time passes.  Third, your portfolio deltas will change as you add or close positions.  Fourth, your portfolio is exposed to factors that are unique to each individual underlying equity which are not captured by Beta weighted deltas.  For these reasons, it is important to monitor and adjust your portfolio risk on a regular basis and as market conditions change.

How Do You get Started With Beta Weighting Your Portfolio?

As with all trading education, paper trade until you’ve mastered the new technique from conception to implementation.  A few suggest steps to get you started:

• Investigate how your platform’s Beta weighting function works. Develop a solid understanding of how it works and how it can be used.
• Determine the $SPY Beta weighted delta of your current or paper portfolio.
• Analyze your portfolio price risk – is it in your target range, are you taking too much, or too little risk based on your parameters and market outlook?
• Determine how many deltas do you want to add to or subtract from your portfolio.
• Analyze your alternatives (on paper) for managing your deltas utilizing your platform’s functionality to determine the best course of action.
• Paper trade the best course of action to see the impact on your portfolio’s price risk.
• Follow these steps on a regular basis until you’re comfortable with the results and then move to live trades.