Measuring Portfolio Risk - PDF Free Download

Measuring Portfolio Risk The first step to hedging is measuring risk then we can do something about it What do I mean by portfolio risk? There are a lot or risk measures used in the financial lexicon. Portfolio Beta, Portfolio Standard Deviation, Sharpe Ratio, Sortino Ratio, and Negative/Positive Portfolio Delta provide some indication of portfolio risk, but these measures themselves are not specific enough to make an informed decision of how much risk to take and how to reduce the risk in the portfolio. Negative Delta portfolios can be deceiving as the negative delta only applies at the current market price. A market decline can cause an options portfolio to quickly turn very delta positive and lose value quickly. Understanding the Gamma risk and Vega risk will help, but this is still only a single snapshot. So, while all these measures give some indication of risk, they don t indicate the magnitude of the losses along the risk curve. The Risk Profile is a graphical representation of the relationship between the portfolio performance versus the index. In options trading this risk curve is not linear and that makes the evaluation of risk very difficult. What I need is a means of determining how much my account will go up or down for a given market movement; something that I can use to model possible option hedge trades to reduce the risk in my account. How risky is my portfolio? My definition of risk is the percentage that my portfolio will decline for a given percentage decline in the market. For example: S&P 500 Index My Portfolio Decline of 5% -9.10% Decline of 10% -19.20% Decline of 20% -32.00% This is very useful information although in this case the information it is not good. I know that if the market declines only 5% my portfolio will decline by 9.1%. In a severe correction, my portfolio will decline by over 32%. In other words, my portfolio loses money faster than the market at large. Is this too much risk to take? Are there investment decisions that I can make to mitigate this? Would I be satisfied if my portfolio declined at the same rate as the market? Would I rather have the portfolio decline at half of the rate of a potential market decline? What would risk mitigation cost? Three trading platforms provide Risk Profile graphs for this purpose; Thinkorswim, Interactive Brokers and LiveVol. IB refers to this graph as the Risk Navigator. Likely there are others used by institutions that I don t know of. TastyWorks will release this feature soon. Most trading software was developed by brokerage houses for buying and selling stock. Today these brokers allow buying and selling options, but their software was never developed for the professional options trader. Thus, the tools that the serious options trader needs are not available from most brokerage houses. The point is that one cannot adequately understand portfolio risk without the software to provide a beta weighted risk profile. Most investors don t even know this software exists. The Risk Profile relies on beta weighting the portfolio to normalize the size of the assets in the account against a benchmark; I use the SPX as the benchmark. I use Thinkorswim (TOS), so the examples here are from TOS.

The Thinkorswim, Analyze Tab, Risk Profile is shown here for a mockup portfolio. The Risk Profile first needs to be setup: 1. Beta Symbol I use is SPX. 2. Date for the current monthly expiration is about 23 DTE; I would not use only a few days. 3. Price Slices Set up for slices noted above. 4. Portfolio, Beta Weighted Be sure this is not set on Single Symbol. 5. Date: - Under Positions and Simulated Trades be sure today s date is selected. 6. P/L Open These are the profit or loss numbers for the portfolio at the price slices (vertical orange dotted lines). Once the Risk Profile is setup I can begin recording the P/L Open values in the spreadsheet below to evaluate the portfolio risk. The spreadsheet is available at www.terrywalters.com/tools.html Enter the details regarding the account in the top portion of the spreadsheet. Also enter the value of VIX and the Greeks. Then enter the values from the P/L Open column of the Risk Profile on the out section of the spreadsheet. The spreadsheet will calculate the gain or loss for the portfolio for market drops of -5%, -10% and -20%. Obviously, this portfolio below will get in trouble much faster than the market in a correction. The portfolio consists mostly of Covered Stock Replacement trades (front month short calls covered by DIM LEAPS calls) and about 45% cash and

cash equivalents. The notional equivalent of the LEAPS calls is double the Net Liq of the account, thus the portfolio is double leveraged. The leverage creates downside risk greater than the market at large. Portfolio Risk Measurement and Hedge Trade Evaluation Date 4/26/2018 Delta 161 Hedge Hedge Cost $0.00 Acct. Sample Gamma -0.86 Strike % of Portfolio 0.00% Net Liq $309,458.32 Theta 243 Paid Cost Per Mo. #DIV/0! VIX 16.13 Vega 2564 Delta Annualized #DIV/0! SPX 2666.94 DTE Base Two Three Account Without Hedge only Hedge only 30 at IV at the 30 IV Line 20% Below the 10% Below the 5% Below the At the SPX 2133.552 2400.246 2533.593 2666.94 P/L Open on the Day Line -$67,942.00 -$28,152.00 $2,980.00 $31,200.00 Portfolio $210,316.32 $250,106.32 $281,238.32 Percent Decline -32.0% -19.2% -9.1% P/L Open on the Day Line Percent of Portfolio 0.0% 0.0% 0.0% P/L Open on the Day Line Percent of Portfolio 0.0% 0.0% 0.0% P/L Open on the Day Line P/L Open on the 30 IV line The risk of losing 19.2% if the market corrects by 10% is more than I can stand. I really don t want my portfolio to decline more than the market and I d like to do even better. A market correction is usually defined as a rapid decline of 10% or more from a recent high. A crash might be defined as a rapid decline of 20% or more from a recent high. Corrections occur about once a year. They seem to come out of nowhere. They are not predictable, but they are probable. A correction is going to happen. Option portfolios often include a fair amount of leverage and thus when the correction occurs, the portfolio may decline very fast. Since options are time dependent we must consider that the decline in the market may last longer than the duration of our option trades. Thus, in a correction the option trader might be forced to close positions at a loss. ets seem to recover from corrections relatively quickly. The real problem is having to take capital losses at the worst possible time and not have that capital for the eventual market recovery. Stock investors can ride out the corrections; option traders may not be so lucky. A crash creates an even worse scenario as it implies greater declines for an even longer period. Here the option trader is more likely to have to take capital losses. What I need is a portfolio the can rise faster than the market and decline slower than the market. Buying puts for protection: Out of The Money (OTM) puts are a common way to add downside protection in a long portfolio. Equity traders see them as expensive; and they are, relative to the gains in stock investing. An options portfolio uses inherent

options leverage and often has greater annual returns than a stock-only portfolio. Thus, there are some gains from options trades to allocate to the purchase of portfolio insurance. The Risk Profile below displays the value of a 10 delta put. Only the hedge put is selected from the Positions and Simulated Trades on the graph. I can enter the P/L Open values for the downside scenarios in my Portfolio Risk Measurement spreadsheet to see the effect of this 10 delta long put in a market decline. Enter the hedge trade data in the spreadsheet Hedge (symbol) Strike #4 Paid (If I buy more than one, I enter the total price.) Delta #6 DTE I check to be sure that Lines: is set to +1@ Date #1

Enter the values in the Open P/L column in the Hedge only at 30 IV section. Portfolio Risk Measurement and Hedge Trade Evaluation Date 4/26/2018 Delta 161 Hedge SPX Hedge Cost $960.00 Acct. Sample Gamma -0.86 Strike 2425 % of Portfolio 0.31% Net Liq $309,458.32 Theta 243 Paid $9.60 Cost Per Mo. 0.19% VIX 16.13 Vega 2564 Delta -9.489 Annualized 1.90% SPX 2666.94 DTE 49 20% Below the 10% Below the 5% Below the At the Base Two Three Account Without Hedge only Hedge only 30 at IV at the 30 IV Line SPX 2133.552 2400.246 2533.593 2666.94 P/L Open on the Day Line -$67,942.00 -$28,152.00 $2,980.00 $31,200.00 Portfolio $210,316.32 $250,106.32 $281,238.32 Percent Decline -32.0% -19.2% -9.1% P/L Open on the Day Line $28,053.00 $7,412.00 $2,224.00 $0.25 Percent of Portfolio 9.1% 2.4% 0.7% P/L Open on the Day Line Percent of Portfolio 0.0% 0.0% 0.0% P/L Open on the Day Line P/L Open on the 30 IV line This hedge long put will contribute about $28,000.00 to the portfolio in a 20% decline in the SPX; the put will cost about $960.00. The put provides a lot of protection but it still is not cheap. If I had these puts on constantly all year long they would cost something like 1.90% of the portfolio Net Liquidation value annualized. But I really want to see is the value of my hedge put when VIX is about 30. When the market corrects quickly, the VIX rises very fast. In the market bump of FEB 2018, the VIX hit a high of over 50 instantaneously and traded over 30 for five straight days. It is reasonable to assume that in a market correction a 10 delta hedge put will inflate in value very fast. Since IV will inflate dramatically when the market declines, I want to determine the value of my put in the correction. To do this I need to make sure the Risk Profile is correctly set up like the graph below. 1. Note the current value of the VIX = 16.13 captured on the spreadsheet above. 2. Select only the hedge put JUN 2425 PUT 3. Click the gear icon on the right of the SPY position line and set the Vol Adj value to 30 minus the VIX; in this case about 13.87. This will create a 30 IV trace on the graph the purple line. 4. Enter the values from the P/L Open column in the spreadsheet in the Hedge only at 30 IV.

1. I have selected ALL of the positions in the portfolio. 2. I have selected Lines: 1@ Vol Step and have set the Step: to 13.87%; this will be added to the current VIX to create the 30 IV, blue line. 3. To read the values of the blue line I must set my cursor first to the -5% orange dotted line at #3. 4. Read the value in blue circled in #4 for the 5% market decline. 5. I then do the same for the -10% market decline setting the cursor at #5. 6. I then do the same for the -20% market decline setting the cursor at #6 7. The value at the can be read from the P/L Open column as that is the current value of the portfolio. Record these values on the spreadsheet.

Portfolio Risk Measurement and Hedge Trade Evaluation Date 4/26/2018 Delta 161 Hedge SPX Hedge Cost $960.00 Acct. Sample Gamma -0.86 Strike 2425 % of Portfolio 0.31% Net Liq $309,458.32 Theta 243 Paid $9.60 Cost Per Mo. 0.19% VIX 16.13 Vega 2564 Delta -9.489 Annualized 1.90% SPX 2666.94 DTE 49 20% Below the 10% Below the 5% Below the At the Base Two Three Account Without Hedge only Hedge only 30 at IV at the 30 IV Line The Bottom Line: SPX 2133.552 2400.246 2533.593 2666.94 P/L Open on the Day Line -$67,942.00 -$28,152.00 $2,980.00 $31,200.00 Portfolio $210,316.32 $250,106.32 $281,238.32 Percent Decline -32.0% -19.2% -9.1% P/L Open on the Day Line $28,053.00 $7,412.00 $2,224.00 $0.25 Percent of Portfolio 9.1% 2.4% 0.7% P/L Open on the Day Line $30,137.00 $12,262.00 $6,713.00 $3,162.00 Percent of Portfolio 9.7% 4.0% 2.2% P/L Open on the Day Line -$39,820.00 -$20,726.00 $5,174.00 $31,180.00 Portfolio $238,458.32 $257,552.32 $283,452.32 Percent Decline -22.9% -16.8% -8.4% P/L Open on the 30 IV line $2,350.00 $30,846.00 $51,714.00 $30,819.00 Portfolio $280,989.32 $309,485.32 $330,353.32 Percent Decline -9.2% 0.0% 6.8% This portfolio would be rather safe in a declining market, for now. If the market dropped by 5% tomorrow and I closed all of the positions on the Vol spike, I might actually make money. The problem is that the blue 30 IV line will move lower day by day until expiration of the trades in the portfolio. Two weeks from now the curve will be much lower as the options in the portfolio mature. The reason for this is that the portfolio has a very high positive Vega noted in #8 on the Risk Profile above. Most portfolios will not be nearly as forgiving of a down market. The hedge put was initially purchased at about 45 to 60 DTE. As we get closer to expiration, the put will only be effective if the underlying declines to less than the put strike. In order to keep some value in the put, I roll to the next month at about 28 DTE again buying the 10 delta put. In the market decline I sell these puts when the VIX spikes. I don t replace the long put hedge until the market is near its high before the recent decline. This saves the cost of hedging with puts when the market is already down. Another portfolio example: The Risk Profile example below is a more typical options portfolio. In this case I simulated a larger portfolio Net Liq and added two hedge puts. The portfolio consists of mostly defined risk spread trades. The Portfolio Risk Measurement spreadsheet is filled out below it.

Portfolio Risk Measurement and Hedge Trade Evaluation Date 4/29/2018 Delta 286 Hedge SPX Hedge Cost $1,740.00 Acct. Sample Gamma -1 Strike 2425 % of Portfolio 0.35% Net Liq $498,490.00 Theta 294 Paid $17.40 Cost Per Mo. 0.22% VIX 15.41 Vega -558 Delta -18.69 Annualized 2.23% SPX 2669 DTE 47 20% Below the 10% Below the 5% Below the At the Base Two Three Account Without Hedge only Hedge only 30 at IV at the 30 IV Line SPX 2135.2 2402.1 2535.55 2669 P/L Open on the Day Line -$153,858.00 -$102,694.00 -$57,148.00 -$11,618.00 Portfolio $356,250.00 $407,414.00 $452,960.00 Percent Decline -28.5% -18.3% -9.1% P/L Open on the Day Line $55,853.00 $14,789.00 $4,537.00 $104.00 Percent of Portfolio 11.2% 3.0% 0.9% P/L Open on the Day Line $60,405.00 $25,031.00 $13,989.00 $6,849.00 Percent of Portfolio 12.1% 5.0% 2.8% P/L Open on the Day Line -$98,004.00 -$87,905.00 -$52,610.00 -$11,514.00 Portfolio $412,000.00 $422,099.00 $457,394.00 Percent Decline -17.4% -15.3% -8.2% P/L Open on the 30 IV line -$85,505.00 -$73,266.00 -$46,044.00 -$11,514.00 Portfolio $424,499.00 $436,738.00 $463,960.00 Percent Decline -14.8% -12.4% -6.9% One thing to note is the portfolio has negative vega; it loses money quite rapidly. At 10% below market the portfolio loses 18.3% of its value. With a couple of hedge puts and an IV spike the portfolio would survive a crash pretty well. The first 5% to 10% decline is difficult, but the hedge puts would more than pay for themselves. Is 2.23% of Net Liq too much to pay annually for this minimum protection; I don t know. As traders we often don t know we have this much risk and we simply trade around the down markets. But when the market is at new highs and my options trades are generating a lot of cash, I am willing to spend some for the hedges. Finally, should I spend the money to hedge? At least now I actually know my risk and now I can make an informed decision.