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Suppose I believe it would be profitable to build an investment portfolio by investing, say, USD 30,000 in stocks in the following ratio: 30% in shares of CompanyA, 30% in CompanyB and 40% in CompanyC. Say that my analysis shows that over the past 10 years, these stocks have performed well as a portfolio, and have a Sharpe ratio of, for example 1,50.

Suppose further that I consider two different strategies.

Strategy 1: invest USD 30,000 directly in the stocks in the ratio mentioned above: 30% A, 30% B and 40% C.

Strategy 2: Instead of investing in the shares of these companies I, would buy long term call options (with a maturity of say 2 years) on these same shares, in the same ratio: 30% calls CompanyA, 30% calls CompanyB, and 40% calls CompanyC.

Of course, there might be large unforeseen shocks that ruin my approach by making my call options go to USD 0, so that I lose my money. But apart from that, (1) is it reasonable to think that the same diversification effect that I expect in strategy 1 would also occur in strategy 2? And (2) what am I overlooking if I would invest in Strategy 2?

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  • $\begingroup$ Options are a bet on volatility. If you want leverage, then just buy the stock on margin. Also, your options will go to \$0 upon expiration anyway if they aren't in the money. $\endgroup$ Jun 26, 2020 at 20:12
  • $\begingroup$ I understand. But I mean, is there such a thing as a "portfolio effect" when buying calls on stocks - in the same way as might occur when buying the stocks directly. So that the overall risk of the option portfolio decrease in the same proportion as when investing in the stock portfolio. $\endgroup$
    – twhale
    Jun 26, 2020 at 20:18
  • $\begingroup$ Only call options? Or may calls and puts be used? $\endgroup$
    – amdopt
    Jun 27, 2020 at 14:43
  • $\begingroup$ Yes, puts may also be used. $\endgroup$
    – twhale
    Jun 27, 2020 at 15:33

1 Answer 1

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Yes and no: diversification always decreases the effects of surprise events (unless they hit the whole portfolio equally) and as such the overall risk of extreme moves. That is true for option portfolios in the same way as it is for stock. But there is a key difference: stocks statistically increase in value so diversification in a stock portfolio decreases the probability/size of downward shocks and increases the probability of a steady uptrend.

However, options statistically DECREASE in value. With options, you have to hit time and strike and if you hit right, you win big but usually you loose. So with a diversified long options portfolio your probability increases to get a steady DOWNTREND of your capital. Basically if you throw darts at the stock market, you win, but if you throws darts at the options market, you lose. Things might well be different building a diversified SHORT options portfolio. And obviously if you have a winning options strategy that can be applied with equal profitability across multiple underlyings, the risk of big one time shocks is decreased for the same reasons as in a diversified portfolio.

Disclosure: I am affiliated with www.leeway.tech and have a personal interest in its success.

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  • $\begingroup$ That makes a lot of sense. And the distinctions you make are very helpful. Thanks a lot. $\endgroup$
    – twhale
    Jun 28, 2020 at 10:57

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