beginners corner

What is Beta-Weighting?

What is the impact on the overall market on our covered call writing and put-selling positions? We know that market movement plays a major role in our stock and options selections as well as our position management choices. In today’s article we will discuss a means of actually measuring the specific sensitivity of our individual positions as well as our overall portfolio to market movement. The technique is known as beta-weighting and has been used by institutional investors for some time and is now available to retail investors who trade with certain online discount brokers such as TD Ameritrade, Options House and Interactive Brokers among others.

The sensitivity of an individual stock to the movement in the broader market is known as its beta. Stocks sensitive to market movements typically have high betas (above “1”) whereas stocks that display low correlation with the market have low betas (below “1”), while some may move in line with the market (betas near “1”). Stocks that move inversely to the market have negative betas. Most commonly beta is measured against the S&P 500 (SPY) but that may vary depending on vendor used and portfolio mix. Stated differently, if the SPY moves a certain amount, how much will that impact our portfolio?

We know that Delta tells us how much our option value will change, given a $1.00 change in share value. If an option for a particular security has a delta of 0.5, it is equivalent to 1/2 share of stock. Stocks always have deltas of “1”. If we are short that option, it is equivalent to (-) 1/2 share of stock. By beta-weighting deltas, options positions can be converted to stock equivalents. By beta-weighting our positions to the S&P 500 we are converting all our positions into one product as a number of shares of SPY. Some positions are long, some short. The closer to delta-neutral our portfolio, the less impact the market will have on our overall portfolio. A portfolio consisting of positions with offsetting positive and negative Deltas so that the position of delta is zero are said to be delta neutral.

 

Why beta-weight and not just go with delta?

All Deltas are not created equal. One hundred Deltas of AT&T have a completely different risk profile than one hundred Deltas of Google. This is because a $1.00 movement in Google is much more likely than a $1.00 move in AT&T due to its higher price and greater volatility. When Delta is converted to a beta-weighted Delta, the profit and loss is based on a $1.00 move in the S&P 500, not in the underlying security. By using a beta-weighted Delta, we can see the market risk of any individual position and our portfolio as a whole. Portfolio managers can also use these stats to see the number of Deltas needed to make a portfolio Delta-neutral. Each portfolio Delta position is converted into its Delta-SPY-equivalent. Then positive and negative Deltas are added to determine the total portfolio Delta-SPY equivalent. That number will dictate whether SPY shares need to be bought or sold to create the Delta-neutral portfolio. Portfolio analysis is done using the S&P 500 as the entity to weight securities against.

 

Why do I bring this up?

I have recently received inquiries about a strategy regarding a Delta-neutral covered call writing-like strategy. It goes like this:

  • Develop a portfolio of stocks based on the BCI Premium Watch List
  • Using the beta-weighting software of our online discount broker, calculate the number of SPY-equivalent Deltas that make up this portfolio (hang in there)
  • Buy or sell an equivalent number of SPY option Deltas making the overall portfolio Delta-neutral (I just love our BCI community)

Although we do not beta-weight our portfolios as many institutional investors do, our Premium Watch Lists to provide beta stats in the “running list” section as shown below:

 

beta and covered call writing

Beta stats from premium Watch List

 

Stats are based on one year figures with a comparison to the S&P 500.

 

Discussion

Beta-weighting portfolios is a technique used by some portfolio managers and institutional investors and even some retail investors to minimize the risk in their portfolios or at least identify the risk. This risk is determined by beta-weighting Deltas to SPY equivalents so no matter which securities we have in our portfolio we are always comparing apples to apples. Frequently, the goal is to establish a Delta-neutral, beta-weighted portfolio.

This concept of measuring portfolio and position risk is already accounted for in the BCI methodology by identifying the implied volatility of the underlying security usually by looking at the 1-month return of a near-the-money strike. This may not be as scientific as beta-weighting Deltas but it is practical and effective. For example, in normal market conditions we may set a goal of 2% – 4% for initial returns for near-the-money strikes. We can adjust higher or lower depending on overall market assessment and personal risk tolerance. I am all for any strategy that identifies and accounts for risk management.

 

Blue Collar Scholar Competition: 

Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)

Sam KS

John G

Bill W

 

Sample Commentary from Joe M:

“I would love to see the S&P finish the year strong and set up a good 2016. I just don’t feel there is enough positive vibe to have any strong moves. Therefore, I used a 12-month standard deviation to project the end of the year”.

The six winners will be published in the January 10, 2016 newsletter.

 

Next live appearance

Saturday January 23rd, 2016: Kansas City, Missouri

9 AM – 12:30 PM

Matt Ross Community Center

Events calendar

 

Market tone

The price of crude oil fell to seven-year lows due to concerns about oversupply This, along with uneasiness over slowing global economic growth, sent lower. The Chicago Board Options Exchange Volatility Index (VIX), increased to a month-long high of above 20 as the Fed watch intensifies for a possible rate hike next week. This week’s reports:

  • US core retail sales (excluding automobiles, gasoline, building materials and food services) increased 0.5% in November, beating the consensus forecast of 0.4%
  • Overall retail sales rose a modest 0.2% in November
  • The prices for US imported goods fell in November for the fifth straight month as a result of cheap oil, a strong US dollar and slow global growth

  • In October, 2.78 million Americans quit their jobs, the second-highest number since the recession, and a sign of increased worker confidence.

  • Initial jobless claims increased 13,000 to 282,000 for the weeking December 5th
  • Weekly jobless claims have remained below 300,000 since early March
  • Continuing claims rose by 82,000 to 2.24 million for the week ending November 28th
  • Foreclosures on US homes fell 21.5% in October from a year earlier
  • The University of Michigan’s preliminary consumer sentiment index rose to a four-month high of 91.8 in December from 91.3 in November. The rise in confidence was tied to cheaper gasoline and brighter job prospects.
  • US producer prices unexpectedly rose 0.3% in November after a 0.4% drop in October. For the 12 months through November, the producer price index fell 1.1%

For the week, the S&P 500 dropped by 3.79% for a year to date return of (-)2.26%%.

Summary

IBD: Market in correction

GMI: 1/6- Sell signal since market close of December 10, 2015

BCI: I’m taking a neutral stance through the December Fed meeting, especially with the rising VIX but still positioned with an equal number of in-the-money and out-of-the-money positions. Any new positions established will be defensive in nature until the market reaction to the Fed dialogue provides clarity.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

Tags:

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

Connect With Us

To send us an email, contact us here. Subscribe to our e-mail newsletter or RSS feed to receive updates. Contact us by phone at 866-892-2187. Additionally you can also find us on any of the social networks below:

16 Responses to “What is Beta-Weighting?”

  1. Barry B December 12, 2015 10:25 pm #

    Premium Members:

    This week’s Weekly Stock Screen and Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 12/11/15.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and the BCI Team

  2. Mark December 13, 2015 2:51 am #

    Alan,

    Can you recommend a free site to get numbers on delta and the greeks. I’m just getting into the greeks and this would be really helpful…thanks.

    • Alan Ellman December 13, 2015 7:40 am #

      Mark,

      Here is a reliable free site and the steps needed:

      Locating Greeks for Specific Options

      http://www.cboe.com

      • Tools and Resources

      • Calculators (left side)

      • Options calculator

      • Enter stock ticker

      • “Go”

      • Adjust for strike in question

      • Calculate

      • For implied volatility enter option price in lower right box

      Alan

  3. Lyn December 13, 2015 4:40 pm #

    Alan,

    I really appreciate your clear explainations of sometimes confusing options issues – generously given.

    On Nov 30 I sold a covered call for $.37 with a strike price of $19 and expiration date Dec 18 (stock was NEM).

    The stock is now selling for $19.13. I don’t want to sell the stock, so want to buy back the call.

    The premium to buy is $1.07, however – 3x what I received for the call. Why, 5 days from expiration when the current price is only $.13 above my strike price, is the premium so high?

    Thanks,

    Lyn

    • Alan Ellman December 13, 2015 5:03 pm #

      Hi Lyn,

      The two forces that can increase option value as expiration approaches are Delta (share price increases) and Vega (volatility increases). Delta appears to be the main factor in this case as I look back on the chart. On 11/30 NEM traded between $17.50 and $18.50, let’s say it was $18.00 when the trade was executed and so the strike was well out-of-the-money. Today, it is in-the-money causing Delta to elevate premium.

      Now I also believe you are viewing an incorrect or the wrong options chain as I see the premium to buy back the option at $0.67, not $1.07 as highlighted in the screenshot below.

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO THE BLOG.

      There are still 5 more trading days before you need to make a possible rolling decision.

      Alan

      • Lyn December 14, 2015 2:23 am #

        Alan

        Thanks so much for your quick response to my off target question. It seems I was looking at the wrong expiration date and therefore the wrong premium. At least it makes more sense now.

        On another note, as long as I have your attention, I came across a very interesting (at least in my mind) option play last week. I sold puts on SunEdison (SUNE) with strike prices of $3.50 and $4.00 and an expiration date of Jan 15.

        The annual return on the premium was in excess of 200% and the price of the stock will be discounted over 20% – if I end up buying it. Just after I sold the puts, the stock rocketed up over 20% in price.

        Tomorrow (unless something strange happens) I intend to buy back my $3.50 stike options (leaving a $19 profit per contract over less than a week) and sell more puts at $4.50 with the same expiration date. According to my calcs, the annualized return on the premium will be 215.9% and the discount over the current price 11.7% – if I end up owning the stock.

        True, the company has been hit hard lately with a class action lawsuit from shareholders over yieldcos and heavy shorting by hedge funds, but they are the largest photo-voltaic panel manufacturer in the US and the maker of the world’s most efficient pv panel. They have big deals going with Google, WalMart, the DOD, etc. Just six months go they were selling for over $30 a share and I expect them to get back there before too long.

        These are the kinds of stocks I like to sell puts on – highly distressed but solid companies with little more downside and huge upsides – and high premiums. I’m happy to own the stocks at a discount, or just the collect the beefy premiums. Precious metals mining stocks fall into this category. I also sell covered calls on some of the stocks I end up owning.

        Thanks so much for getting me started in this lucrative investing arena. I’ve only been doing it for less than a year and still have a lot to learn. Your three “encyclopedias” on puts and covered calls are invaluable in this regard.

        Many thanks,

        Lyn

        • Alan Ellman December 14, 2015 7:53 am #

          Lyn,

          The figures you present define a highly volatile underlying security. Implied volatility measures market anticipation of the price movement of a security from its mean price based on 1 standard deviation (falls into the expected range 67% of the time). It does not define direction so share price can go up or down. Therefore, the good news is the juicy premium and the bad news is the implied risk undertaken.

          Based on our personal risk tolerance and return goals, we can make an assessment if these are the right trades for us. Good for some, inappropriate for others.

          Alan

    • Jay December 13, 2015 10:03 pm #

      Lyn,

      Thanks for posing one of the essential questions we face as covered call writers: what to do when a stock we like goes up?

      I have not yet learned to be as dispassionate a business person as Alan who says “Great. I hit my target, which stock is next?”

      I would say in the case of your NEM we are about to enter one of the more volatile market weeks we have seen. I bet you can get out of that call on any dip for less than you sold it for. In fact, this week has the potential to be so ugly you will be glad you sold covered calls! But it is always darkest before the dawn and Santa is on his way…

      Please do not use me as anything other than a contrary indicator. Mea culpa: I am the guy who predicted a calm week last week!

      Best of success and Holiday wishes to our community! – Jay

      • Joe M December 15, 2015 12:05 pm #

        Jay,
        You know I always like your take on the state of the market. However, this year, I think even Santa with his bag of goodies and Janet with all her helpers isn’t going to salvage 2015.

        For me, Covered Calls has helped mitigate an otherwise forgettable year. I am thankful for finding this website just over a year ago. I am thankful to Alan for pulling it all together to make it understandable for me. Finally, I am thankful to all the posters and contributers to these blogs who ask the questions I have yet to even think of.

        Happy Holidays to all and here’s to a better 2016 !!

        Joe M

  4. Steve December 14, 2015 8:02 am #

    Alan,

    One thing I don’t think I have seen mentioned is the use of stop-loss orders on underlying stocks. I would always have an e.g. 10% trailing stop on my share positions, but if I then later decided to sell an option on that position, I assume it would be MANDATORY remove all stops, otherwise be at risk of having an uncovered option.

    • Alan Ellman December 14, 2015 8:10 am #

      Steve,

      You are 100% correct. When using covered call writing, it is imperative to close the short option position before the long stock position. As a matter of fact, most brokers will not allow us to end up in a naked option position unless we have consent for a higher level of trading approval.

      The 10% trailing stop loss order is what I teach in my book “Stock Investing for Students”, a long-term investment plan without the option component.

      If we decide to sell a call on a long-term position, remove the trailing stop and enter a limit order to buy back the option at the appropriate price (I use the 20%/10% guidelines). Once executed we can then move forward on the stock side.

      Alan

  5. Ralph December 15, 2015 9:53 am #

    Alan,

    I own 500 shares of Amazon in an IRA. I paid in the low 500s. Is this a good stock for covered calls for january?

    Thanks,
    Ralph

    • Alan Ellman December 15, 2015 12:56 pm #

      Ralph,

      Since you are trading in a sheltered account, there are no immediate tax issues relating to short-term capital gains or exercise. If you want to retain the shares, you should favor out-of-the-money strikes. If it doesn’t matter to you, all strikes are open for consideration. Also, monthly returns must meet you goals. As I type, AMZN is trading near $668.00. I selected 3 strikes randomly (NOT necessarily recommendations). Check the screenshot below of the multiple tab of the Ellman Calculator and look at the right side to see if these stats meet your goals (Initial returns, upside potential and downside protection).

      CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

      Alan

  6. Alan Ellman December 16, 2015 5:06 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  7. Maureen December 18, 2015 2:46 am #

    Alan,

    On page 281 of your Encyclopedia Vol 2 there is a chart of implied volatility of various ETFs with a discussion of risk compared to the S&P 500. My question is this IV for all strikes and expirations? If not, which ones are more sensitive to changes in IV?

    Thanks for your teachings. I can’t believe I know enough to even ask these questions!

    Maureen

    • Alan Ellman December 18, 2015 7:45 am #

      Maureen,

      You’re doing great…excellent questions:

      1- Our BCI reports use a weighted average of implied volatility for both put and call options so it is a broad, meaningful reflection of overall risk.

      2- Options most sensitive to changes in IV (have higher Vegas) are longer-term options and those near-the-money).

      Alan

Leave a Reply

Optionally add an image (JPEG only)