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Beta-Weighting By Correlation

Options Jive

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Many of the staff at tastytrade worked together at thinkorswim where they pioneered the idea that retail investors should be able to Beta-Weight their portfolios against a market index. This enabled more effective hedging. Beta-weighting is usually done against SPY, the ETF of the S&P 500. Is this the best index to use or is another choice a better one for gauging our overall risk?

A key criteria for Beta-Weighting to be effective is for our positions to have a high correlation to the index chosen. The number is meaningless without the high correlation. Imagine you have a portfolio comprised of trades exclusively in highly liquid stocks like AAPL, AMZN, FB, GOOG and NFLX. Is the S&P 500 the index we should be using, or is the Nasdaq 100 a better choice? A table of the correlation of AAPL, AMZN, FB, GOOG and NFLX to the Nasdaq, S&P 500 and the Russell was displayed. The table showed that the portfolio clearly had the highest correlation to the Nasdaq.

Traders can use QQQ to understand the index Delta exposure. A table of varying positions in the stocks mentioned and their Delta exposure to the QQQ (Nasdaq ETF) was displayed. The table included the underlying, current price, option position, Delta and QQQ Delta. The table showed a big difference between the option position Delta and the QQQ Delta for the same trades. Tom made the point that "this kind of invaluable data separates tastytrade from the rest of the investing world." Using the QQQ for Beta-Weighting showed that the portfolio is much shorter than what the product-specific deltas demonstrated. It’s an excellent measure of the net long or short bias. Please bear in mind that these values don’t take into account any change in implied volatility (IV) or time decay of the option positions.

For more segments related to this subject see:

Best Practices from October 19, 2015: "Understanding Correlation"

Options Jive from February 29, 2016: "Correlation | Is Your Portfolio in Trouble?"

Options Jive from March 8th, 2016: "Beta & Correlation | Keeping Model Risk in Check"

Best Practices from May 2nd, 2016: "Four Facts About Correlation"

Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of the importance of correlation and Beta-Weighting to the right index or ETF.

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