Episode 03

Portfolio Risk Management with JJ Kinahan

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Listen to JJ Kinahan, Chief Market Strategist at TD Ameritrade, and his guests explain portfolio risk management strategies that use options.

Audio Transcript

JJ: This is Understanding Options. I'm your host, JJ Kinahan.

Victor: Hello, everyone. I'm Victor Jones, director of trading at TD Ameritrade. Welcome to TD Ameritrade chief market strategist JJ Kinahan's podcast series, Understanding Options. Today JJ and I are joined by Kevin Hincks and Scott Connor from TD Ameritrade and Tom White from our affiliate advisory service, TradeWise.

JJ: Welcome Kevin, Scott, Tom. Thanks for joining us to discuss the important topic of portfolio risk management. Thanks, Vic, for hosting today.

Victor: Yeah, I was wondering, JJ-- first of all, thanks for having me, but I'm curious, can you discuss a little bit about what we actually mean when we talk about portfolio and portfolio risk? What do you consider to be kind of an ideal portfolio?

JJ: So I'll start with portfolio. Portfolio really comes down to what are your holdings? That's your portfolio. Ideal portfolio, you'll read a lot of things that it has to have a certain amount of bonds, a certain amount of stock, a certain amount of foreign exposure, et cetera. I think the most important-- I do think a portfolio should be diverse and that is-- there probably should be some fixed income in most people's portfolio, some stocks. I will say this-- the most important thing to me that you have in a portfolio is a, one that you understand the risk of every product in there. Too many times, I see people with big bond holdings and they're not even really sure what their downside exposure is with bonds. Or they hold stocks that, you know, of a company-- they don't even understand how the company makes or loses money. So the first part in a portfolio, to me, is to understand what's in there and it matches your longer term goals.

There are a few steps I like to take in the process. Set longer term goals and objectives, develop your trading plan, identify what opportunities fit those objectives, enter or open your trades, and then, most importantly, once you have a trade on, monitor it and adjust it and exit those positions as needed. And I will say this, the last thing on that-- please monitor at least once a quarter, even if you're not someone who considers themselves a trader but more an investor. Plan your retirement longer than you're going to plan your vacations.

Victor: You know, you know what's interesting, JJ, is people have more choice in terms of their investment vehicle today than they ever have in the past. And sometimes that's good, but in some ways that can sometimes be intimidating. You know, many people are familiar with mutual funds, they might be in their retirement account, their 401K, whatever the case may be, and some people have experience with stocks. Not many people tend to have as much experience with options. And Tom, I'm curious, why do you think that tends to be the case?

Tom: I think the complexity of the option markets initially puts a little bit of fear, and maybe it's some of the media that puts a little bit of fear. You hear that word derivatives, and a lot of clients start to panic a little bit because they think it's maybe some product that is too complicated for them and the game's against them. But it's actually the opposite, I feel, and the education that we offer at TD Ameritrade to kind of show people that, yeah, options might have risk to them, but so does owning a stock, just like we had stated before in the last podcast about buying 100 shares of Apple. There's a lot of risk in that particular trade as far as capital goes.

So I think the ways that you can use options, whether it's speculation, hedging your portfolio, hedging your risk, enhancing your value of your particular portfolio or existing positions-- really important and getting that conversation started with clients and telling them that, hey, options can be risky just like stock can be risky. But here are certain ways that you can actually use options to your benefit, and maybe enhance your portfolio and protect any risk that you might have on the upside or downside.

Scott: Hey, Victor, I could also speak just a little bit to, you know, for clients if they're looking for educational resources, some of the things they could turn to. There's a lot of resources available. There's no real reason why an investor needs to learn all the advanced options strategies, like condors and things like that. There's a lot of basic strategies, like covered calls or protective puts, that we can use. And getting started, for example, with covered calls or cash-secured puts and go from there.

So let me just give you a quick example. For someone who's building a portfolio, since that's our topic today, cash secured puts can certainly be something they might want to consider because what you're doing by selling a put is if a stock gets down to that strike price, and you have an obligation to buy the stock at that price-- well, if it never gets down there, you'll just keep the credit from that put, but you have to be prepared to buy the stock if it does get down. So that's an easy way for some people to consider a strategy to get started with a portfolio or add to an existing portfolio.

And then again, covered calls-- we can actually apply a strategy like the covered call, which we often refer to as an enhancement strategy, to an entire portfolio. And people can join in the Swim Lessons on Fridays right through the Thinkorswim chat room, and we're actually have sort of a diversified portfolio of stocks that we're actually executing some of these examples we just spoke about.

Victor: And along with the idea of education is really just educating yourself on risk. Tom, you talked about those elements of risk earlier. You know, it's true-- options trading is not necessarily suitable for every single investor, of course. It depends kind of on their own risk objectives, and the risk can really range. You know, JJ, I'm kind of curious here. What are ways that, if we think about risk the other way, what are ways that investors can use options to protect a portfolio?

JJ: Sure, Vic, and you know I equate some of the protection to insurance, in a sense, particularly for those who are more, as Kevin's talked about in some of the past podcasts, is the difference between somebody who's more of an investor and somebody who's more of a trader. And so, you know, you buy insurance on your car, your health, your home. I feel like I am a commercial for an insurer.

Vic, you might want to get your life.

But what people don't realize is that you can buy-- oh, again, I'll call it a corollary kind of protection for a stock portfolio. That is, buy puts on products like the S&P 500 Index. It's, you know, the puts are designed to increase in value if the stock market falls, and the S&P 500 Index is something that takes into account-- most stocks have a corollary number to the S&P 500. And so many portfolios that many of us will have will resemble the S&P 500 in many, many ways. So if you increase the value of your puts, it can help offset losses in a normal stock portfolio that will go down as the S&P goes down. I mean, we could talk about the S&P 500 options all day, and I'm certainly not suggesting that everyone just go out after listening to this and say, "I need index puts!" But it's something to probably learn about because just as you have an option to buy flood or earthquake insurance on your home, you can also buy a measure of protection for a stock portfolio. And you're not obligated to, but again, if you feel the need, it's something to consider for the downside. But as everyone has said and always bears reiterating, please understand the risks that go along with an option.

Victor: I really like the analogy you're using there, JJ, with insurance in that, you know, put options cost money. That's their premium, and what it does is help to insure the value of whatever you're insuring against. You know, just like insurance, if you never have to utilize it, you're still going to lose the premium that you pay for insurance. You lose the premium you pay for the put option, for example. Kevin, what are other ways investors use options, you know, along with what JJ just mentioned.

Kevin: You know, using options is interesting because you tell me how you want to do it, how aggressive you want to be, and I'll figure out a strategy for you, right? I mean, some people want to use a lot more capital to hedge their risk. Some people want to do it, like me-- I like to figure out the cheapest possible way for the biggest bang for my buck. I'm always constantly in search of the cheapest way to get from point A to point B. But you can do that. Spreads are a great way to limit-- you can talk about buying puts, Scott mentioned, on your portfolio, right? Well, buying a put spread. If you think the markets can trade down in a range, a spread will be less money paid out with a lower breakeven price. Right? If you were to use spreads. So understanding the difference between plain options and option spreads is a big hurdle for investors.

I mean, just remember-- when you add options, you add transaction costs. There's a cost to doing business, right? If you add four sides-- we talk about it all the time. Iron condors are very popular, but it's four sides. You have to understand commissions are involved. But if you do it correctly, commissions will be something that is just part of doing business. So understanding spreads, though, is vital.

JJ: And, Kev, one of the things I love when we talk about this a lot is, you know, all five of us in this room might see a need, whatever, for protection for the downside, and all five of us can go and approach it in a different way for what we think is appropriate for us at that time. And so I think it's very important that people understand that. What, you know, Kevin may think is appropriate may not be what Scott thinks is appropriate, may not be what I think is appropriate. So you can go about this any way you'd like. As long as you understand the risks ahead of time, you can put on whatever strategy you'd like. It may be a one leg, it may be four legs, as Kevin just talked about. That's awesome. But the big thing to understand is do the risks and rewards of the strategy match my overall portfolio needs and what I'm ready for at that time?

Victor: Yeah. You know, I used to be on the trade desk, and one of the questions we would ask our clients is, what is your risk? And what we would find sometimes is, you know, clients couldn't really answer that question, and sometimes you take on a position that's either going to add risk to your portfolio. Sometimes you're taking on a position, like you're mentioning, which is potentially decreasing your risk. And so, Scott, I want to start with you. What are ways that you think about or manage risk, essentially, ahead of time, in terms of portfolio? How do you think about measuring total portfolio risk?

Scott: Right. So we're looking at a stock portfolio, for example, the one we look at in the Swim Lessons on Fridays. It's actually, Victor, it's a little bit more simple than you might imagine, because for every stock-- stocks don't have Greeks. Right? They have what's called delta. Now, that is one of the Greeks, but we don't have to worry about the other Greeks. For every share you have, if the stock moves up a dollar or down a dollar, that's exactly how much you lose on that particular stock. So what we're able to do is take an entire portfolio, add up the deltas of all those stocks, and then if each of those moves up or down $1, you can assess what that total risk is on your portfolio.

Kevin, I believe our portfolio has about 4,500 deltas. Meaning if every stock moved up or down, the total shares is 4,500, that's our risk. We could make or lose $4,500 on a daily basis. So that's one easy way. Now that the benefit from that is, by using the beta weighting tools on the thinkorswim trading software, we can now go ahead and use options to make appropriate protective type strategies, like JJ mentioned. Puts or, Kevin, put spreads, things like that. Now, there's also some other tools available, one called the portfolio planner tool, and that's on TDAmeritrade.com. That can certainly help in that respect, as well.

JJ: You know and Scott-- the portfolio planner tool is really a good one, particularly, for people who are just for the first time thinking of their longer term investing because it will require you to really think strategically about things because the markets, as we all know, can and do change. And so even the newly approved options traders, you can start, as you mentioned earlier, with a very basic level-- even if it's just covered calls or cash-secured puts. I mean, even if you never go further than that, that's awesome. You're using a tool out there to help you, you know, hopefully enhance your return, and if the complex strategies are more appropriate, that's great. If they're not, good for you. You know, because some of these strategies are going to work better for longer term objectives. Others will be more short term. Depending, the time frame you pick for your options are certainly a big difference between a weekly and a LEAP. So that makes a difference, too. And as Victor mentioned, some will add diversification. Some will just be used for risk. Some can actually add risk. So you have to understand what will happen there.

But this was a great discussion, guys. I think it's awesome. It concludes today's show. You know, tune in-- we're going to do our next podcast on exit rules. So Kev, Scott, Tommy, thank you. Vic, thanks for hosting, as always. And most importantly, a big thank you to all of you for listening today. We appreciate it, and good trading everybody.

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