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Wednesday, July 25, 2012

Portfolio Beta Weighted

During my usual Weekend Portfolio Analysis articles you have probably seen me doing a Portfolio analysis where all the positions in the portfolio are combined in a single profit picture. This is done by using the Beta Weighting feature of the ThinkOrSwim platform. Today I want to talk a little bit more about what Beta and Beta weighted portfolio mean, and why it is advantageous to do this type of analysis.

First, what is Beta?
Beta is just a measure, a number that defines how fast a stock or any instrument for that matter, moves in respect with the overall market (Usually the S&P500 is used as the benchmark).

So for example, an instrument that moves in tandem with the market, and at the same speed has a Beta of 1. Let's say a stock that moves up by 1% when the market moves up 1%, or 2% when the market moves up 2%, that is a stock that moves at the same speed and direction and therefore it has a Beta of 1.

If the stock is more volatile, that is if it moves faster than the market, but still in the same direction, its Beta is higher than 1. So, if the stock gains 2% when the market gains 1%, then the Beta of that stock is 2. And presumably it should advance 4% if the market moves up 2%.

Likewise, those instruments that usually move contrary to the market have a negative Beta. Say for example a stock that moves up 1% when the market loses 1% has a Beta of -1. Or a stock that moves up 2% when the market declines 1% has a Beta of -2. Presumably, this same stock with a Beta of -2 should move up by 4% if the market loses 2% on any given day, and it should lose 4% if the market moves up by 2% on any given day.

When you Beta weight an entire portfolio, you are combining all your open positions into one single profit picture reflected on the movement of an instrument of your choice (I use the SPX). This way, you can have an idea on the health of the portfolio: how is all the capital going to perform in respect with the movement of the S&P500? Do I have an overall bearish or bullish exposure at the moment? When should I as a trader be concerned that my portfolio is in danger of losing too much money? Where are my break even points in respect with the possible movement of the S&P500 index? And then before adding new positions, you can always analyze how beneficial this addition is going to be to the whole portfolio. Did my breakeven points in respect with the S&P500 widen? Did they shrink? Did I add too much of a bearish exposure when I was already super bearish?

If you are trading a single stock, you probably don't care too much about Beta Weighting your portfolio. There is only one position to manage, and that position by itself represents all the profit or all the loss you can have on the portfolio during that period. However, when you have more than one position, specially more than 3, this analysis becomes more useful.

Let's say ABC is listed at $100 with a Beta of 1.5, that is it moves in the same direction as the market but 1.5 times faster. Let's also assume for simplicity in the maths that the value of the S&P500 index is 1000.

If you sell $130 strike Call options of ABC, you don't want ABC to hit the 130 price. That is 30 points above current price. A movement of 30 points for ABC represents a +30% upside move. Given that the Beta of the stock is 1.5, this +30% move would presumably be achieved if S&P500 moves up 20%. That is if S&P500 reaches 1200, then the stock will probably be trading around $130.

Now, let's add another ingredient to the portfolio. Let's say XYZ is trading at $100 as well. XYZ has a Beta of 1 and you invest the same margin as you did with ABC but this time selling Puts. You sell $90 strike Puts.

You don't want XYZ to go down to $90. That is you don't want XYZ to lose 10%. A loss of 10% for XYZ is the equivalent of a loss of 10% for the S&P500 in this case because XYZ has a historical Beta of 1, meaning it moves in tandem with the market and at the same speed. Now, a loss of 10% for the S&P500, at 1000, is a move down to 900.

If we combine the Calls sold on ABC and the Puts sold on XYZ into a single position Beta weighted vs the S&P500, We have a unique profit picture that tells us that we should be profitable overall as long as the S&P500 index stays in the 900 - 1200 range at options expiration. In the practice the real breakeven points are a little bellow 900 and a little above 1200 due to the premium received by selling the options. Now, with S&P500 at 1000, I am closer to the lower end of the profit picture. Ideally, in order to be more comfortable I would like the index to move up to 1050, which would put both break even points at the same distance from the index. In other words, with this position I get a benefit if the markets move up as I am already more bearish than bullish, while I'm employing a Neutral trading strategy based on Theta decay.

Imagine now that you have 5, 10, 15 positions! The calculation becomes impossible in your brain. It becomes even harder to do when you have more capital invested in some positions and less in others, which skews you portfolio bias. This is when your brokerage platform can assist you in Beta weighting versus a given index so you have a better idea of all your risks combined and can also design a plan for future positions to open.

Using the ThinkOrSwim platform this is easily done:
  • Go to the "Analyze" tab
  • Enter you beta symbol on the top left corner. I prefer SPX.
  • Change the Combo Box that says "Single Symbol" to "Portfolio, Beta Weighted"
  • Change the Combo Box that says "Show All" to "Hide Simulations" if you only want your current positions to be Analyzed
  • Change the Combo Box that says "Show All" to "Hide Positions" if you only want simulated positions to be Analyzed
  • Alternatively click on the symbols bellow the comboboxes and the different positions you want to combine. This is useful when you want to combine current open opsitions with possible new trades you haven't entered yet
Once you are done with your selections you can see a unique profit picture of your whole portolio. For example in my current portfolio I have two RUT Credit spreads open. I can select both, Hide Simulations, and Beta Weight vs the SPX index like so:

(Click on image to enlarge)

And now I can see how my portfolio behaves in terms of possible movements of the SPX index.
The beauty of this technique is that it also allows you to analyze complex positions made up by the different instruments. In this case I'm only trading the RUT index, but I could for example be selling Put Credit spreads on QQQ and selling Call Credit spreads on something else, DIA for example. In reality, when you look at it, you have an Iron Condor position! But it is just an Iron Condor using different instruments. And using the Beta Weighting feature you can see your Iron Condor like exposure, which wouldn't be possible doing a symbol per symbol analysis.

One final note. The Beta of an instrument is variable. If an instrument has a Beta of 1, but it doesn't move in the same proportion as the market does on a given day, then its Beta changes, to something slightly different from one. Beta is therefore constantly changing. Thus, Beta Weighting your portfolio is not a 100% accurate study, but it still gives you a general idea on how you are doing. In my experience, although the Beta of instruments changes, the variations of the combined profit picture in terms of break even points are usually less than plus/minus 1% during a whole options expiration cycle. Which is one of the advantages of trading Indexes and ETFs whose correlations with the market don't change abruptly from day to night.

I hope this article helps in your becoming a more successful trader.



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