Market Measures

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Diversification: Direction Vs. Neutral

Market Measures

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In a traditional stock portfolio context, we look to increase diversification by adding stocks that have unrelated price movements. For example, utilities, gold, and euro tend to move on their own relative to the S&P 500. Does this diversification hold for neutral option trades?

The Study:
  • Compared 1 standard deviation (16 delta) strangles correlations in SPY to various market sectors including:
    • Currencies
    • Commodities
    • Interest Rates
  • Computed Correlation of Strangle P/L
  • 45 DTE Options
  • Trades Managed at 50%
  • 2010 to Present
Results:

We see that correlations which were previously high for stock prices are reduced when we trade neutral strangles. Strangle positions tend to move more independently across assets than prices. If we want to add diversification to a portfolio, we may consider adding neutral strategies which exhibit lower correlations than the underlying asset prices.

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