Building An Option Portfolio (without overthinking)

Successful option traders don't just win trades; they build portfolios. In this video, we're going to run through the concepts that most traders never take the time to figure out or understand before they start building those portfolios, such as the portfolio Delta and the overall directional bias that you have with all your positions, or the portfolio Theta and the aggregate time decay that you are collecting or wanting to collect from the market. Also, what should you be looking for on a day-to-day basis so that you can recognize when things are working and, more importantly, when they're not?

So, welcome to our newest crash course: How to Build a Portfolio in Four Easy Steps. My name is Jim Schultz, and I am very happy that you are here with us today. I'm going to try to make this crash course as quick, concise, and worthwhile as I possibly can.

What we're going to do in these four episodes is take a bird's eye view of building your portfolio. I would argue this is more important than which strangle you're going to sell, what stock you're going to trade, or which earnings announcement you are interested in. So, yes, this is going to be a four-episode crash course: super quick and super to the point.

Here is what we're going to do: In episode number one, we are going to establish your portfolio goals; in episode number two, we're going to talk about the power of using indexes first; in episode number three, we're going to look to add individual stocks; and in episode number four, we're going to talk about the day-to-day portfolio management. So, without further ado, let's do it! Man, let's dive right into episode number one: establishing your portfolio goals.

Okay, so step one—and this is mission critical—this needs to happen before you place a single trade. This needs to happen before you look to put on a single position. You need to map out what you want your target Theta and target Delta to be at the portfolio level.

In other words, how valuable do you want time to be for you at the portfolio level, and how valuable do you want direction to be for you at the portfolio level? Doing this, man, will give you incredible guidance and clarity with your day-to-day decision-making. What you're quickly going to notice is that every decision you make—the new trades, the closing trades, the position adjustments—all these can be traced back to these overarching portfolio goals.

Now, we're going to talk about each of these targets in more detail in just a minute, but let's take a look at your Theta. If your portfolio Theta is too low, then you're going to be actively seeking significantly positive Theta opportunities with your new trades. This makes sense!

But what if your portfolio Theta is too high? Which, yes, by the way, this is a thing. Then you're going to be more cautious with adding more Theta, and instead, you're going to be looking for ways to reduce your Theta exposure.

Now, what about your Delta? Are you more bullish than you would like to be? Well, then you'll look to add bearish positions or close bullish positions.

Are you more bearish than you'd like to be? Then you'll do the opposite: add bullish positions and close bearish positions. And if you like your Deltas, well, then you'll be looking for some more neutrally based positions.

Those will be your go-to. By determining your portfolio goals at the start like this and then using them as your guide, you're able to reduce a ton of subjectivity in your analysis and remain far more objective. All right, so now let's turn our attention to Theta in a little bit more detail.

What we're going to do is we are going to look to target a percentage of net lick or net liquidating value in daily Theta. What this is going to do is add an incredible amount of context around what this number means and what it can do for us. Here is what I mean: Generally speaking, we tend to fall in a range of 0.

1% to 0. 5% of our net lick in daily Theta. The number that you see at the very top of your platform numbers on the lower end of the spectrum, like 0.

1%, is more conservative, whereas numbers on the higher end of the spectrum, like 0. 4% or 0. 5%, are going to be a lot more aggressive.

The numbers in between, of course, like 0. 2% and 0. 3%, are kind of middle of the road.

To put these numbers into a portfolio context: 0. 1% on a $50,000 portfolio is $50 in daily Theta, whereas 0. 5% on that same $50,000 portfolio would be $250 in daily Theta.

On a $200,000 portfolio, 0. 1% would be $200 in daily Theta, 0. 3% would be $600 in daily Theta, and 0.

5% would be a whopping $1,000 in daily Theta decay. Now that we've built a little bit of a foundation for our portfolio Theta, we can lean on the tasty research, which has shown we can expect to capture about 25% of our daily Theta. This accounts for all the big winners, all the big losers, and everything in between.

What this is going to do is give us a great reference point for returns when it comes to our daily Theta capture. So, assuming 360 days in a year to keep all the accountants happy, a 0. 1% in daily Theta would be 36% for the entire year.

But we only expect to keep a quarter of that, so we net out to a 9% return—not too shabby! And you can clearly see that this number scales with more daily. .

. Theta, with 0. 2% coming out to 18% a year, and so on and so forth.

Now, some of you out there, after having heard that, are kind of licking your chops. You're like, "Man, this is some really, really good stuff! " And rightfully so.

I mean, positive Theta and daily decay, these are some powerful, powerful allies. But let's make sure that we all understand something: these are just reference points; these are just theoretical markers. It's never going to be as simple as just putting on your half a percent in daily Theta, kicking your feet up on the desk, collecting your 45% returns, and then doubling your money every 18 months.

It's never going to work out that cleanly, which is a perfect segue into our next topic and our next target—Delta. So, now that we have a Theta foundation, let's turn our attention to Delta. The interesting thing about Delta is that there are effectively three different options you can choose, three different pathways forward through the forest, if you will, each of which has its own set of gims and gachas.

So, effectively, the first thing you'll need to decide is what directional bias you want to have in the market. Do you want to be bullish? Do you want to be bearish?

Do you want to be neutral? Again, a strong case can be made for each of these. The market tends to go higher over time, and the positive drift in the geometric Brownian motion asset pricing model effectively ensures that it will.

So, for that reason alone, you might want to be bullish. But the big, high-velocity moves in the market usually happen to the downside, and these moves generally coincide with expanding volatility. So, a short Delta bearish portfolio can be a nice hedge against your short premium option positions.

Lastly, you might want to remove direction entirely from your portfolio returns, which a number of traders like to do, and just be delta neutral. You have to choose your own adventure here, and any of the three can be successful over time. So, let's work through how to get started with each bias.

If you want to be bullish, then I think a great way to position your portfolio is relative to the SPY index itself. Here’s what I mean: for instance, with the SPY currently around $450 a share, that means that 100 shares of SPY is equivalent to about $45,000. That means that if you had a portfolio that was also equal to $45,000, then 100 beta-weighted Deltas at the portfolio level would be the same as 100 shares of SPY.

Thus, you would have a one-to-one leverage in your portfolio relative to the index. If, however, you had 200 beta-weighted Deltas in that same $45,000 portfolio, then you are effectively controlling 200 shares of SPY, which has a notional value of $90,000. Thus, you have a two-to-one leverage in your portfolio relative to the index.

As another example, let’s say you had a $180,000 portfolio; here you have four times the notional value of 100 shares of SPY. So, your starting point to have that same one-to-one leverage isn’t 100 beta-weighted Deltas or $45,000; that's only a quarter of your portfolio. Instead, it's 400 beta-weighted Deltas, which has a notional value of $180,000—the same value as your portfolio.

If instead, you had 600 beta-weighted Deltas, that would be a one-and-a-half-to-one leverage ratio; 800 beta-weighted Deltas would be a two-to-one leverage ratio; and 1,000 beta-weighted Deltas would be a two-and-a-half-to-one leverage ratio, and so on. All right, so that’s how to think about your portfolio Deltas if you're bullish. But what if you're bearish?

Well, it's going to play out a little differently. Let's have a look. If you're bearish, you could use the same leverage relationships that we established in the bullish context, but it's probably even more helpful to think in terms of your Delta-to-Theta ratio.

Remember, guys, a big reason that you are bearish in the first place is to protect your short premium, and your Theta number is a representation of how much short premium you have. So, using a Delta-to-Theta ratio shows you just how much protection you need. The key here is to lean on our research and strive for a Delta-to-Theta ratio of about 1 to 2—so one short Delta for every two positive Theta.

This makes it pretty easy because you already know your portfolio Theta numbers from the work we did just a few minutes ago. So, with that in hand, you can easily figure out your short Delta target. For example, if your daily Theta target is 100, then you're looking for about 50 short Deltas.

If your daily Theta target is 500, then you're looking for about 250 short Deltas, and so on. The great thing here is this already accounts for your portfolio size, as that was included in the Theta calculation itself. So, this ratio can be applied more quickly and universally.

Okay, so that’s the bullish case and that’s the bearish case. But what about the neutral case? Well, as luck would have it, this one is actually going to be the easiest of the three.

So, let’s have a look. With Delta neutrality, it's pretty simple: you want to keep your portfolio Delta as close to zero as you possibly can. Now, given the fact that we’re retail traders and commissions and transaction costs begin to add up really quickly if we try to peg our portfolio Delta to exactly zero, we can just focus on keeping our portfolio Delta within a range of neutrality—anywhere between plus or minus 0.

1% of net lick is close enough to zero that we can classify it as pretty Delta neutral. For example, on a $10,000 portfolio, that's going to be a range of plus or minus 10 deltas. On a $50,000 portfolio, that's going to be a range of plus or minus 50 deltas, and so on.

If your deltas move outside of that range, then you make the necessary adjustments with both your new trades and your existing positions to bring it back in line. It's really that simple. So, there you have it, guys; that's how to establish your portfolio goals.

It's up to you to now decide how to take this information and apply it. Before I let you go, let me give you a couple of points of guidance. First, you might naturally be wondering, "Jim, why didn't you include Vega?

" Because when it comes to option returns, there are three pieces: there's Theta, there's Delta, and there's Vega. Well, Theta and Delta already cover so much ground that I'm not sure that you're going to derive any incremental benefit from tracking your portfolio Vega as well. Not to mention, now you also have another metric that you have to babysit; you have another metric that you have to target, and at a certain point, that becomes significant, right?

At a certain point, there are too many cooks in the kitchen, and it's difficult to move forward in any meaningful way. So that's why you don't see Vega included in this discussion. Second, many of you out there, especially you new traders, my heart really goes out to you guys that are just starting out.

Man, it's like drinking from a fire hose! I totally understand—you’re thinking, "Jim, I have no idea, man! I don't even know where to begin!

" Well, here is a really great starting point, and then you can adjust and customize later on. First, start with 0. 1% of net lick in daily Theta.

It's very conservative; you can ramp this up later as you gain experience and get more comfortable. If you want a long portfolio bias, which is totally up to you, then start with a 1:1 leverage ratio in exactly the same manner as we went through how to figure that out. If you want to be short, then just target a 1:2 Delta Theta ratio.

These ideas, these guide points, they will give you a great foundation. They will give you a great starting point for establishing these portfolio goals, and then you can adjust and customize accordingly as you move forward along the learning curve. And just like that, guys, we made it through Episode Number One: Establishing Your Portfolio Goals.

Whenever you are ready, I will see you in Episode Number Two of this crash course, where we are going to talk about the power of indexes—the power of using indexes. First, back in Episode Number One, we kind of built up our foundation, looking at portfolio Theta and portfolio Delta. Well, what we're going to do now as we look out to build out the specific positions in our portfolio is start to fill in some of the mortar between those foundational bricks.

So let's do it, man! Let's not waste any more time; let's dive right in to Episode Number Two: The Power of Using Indexes. So, the real power behind using indexes is actually really simple; it's going to give you a smoother ride from start to finish.

Basically, by definition, this has to be the case, right? Because when we look at an index, we're talking about the S&P 500, the NASDAQ, and all these other guys. By definition, they are comprised of hundreds and hundreds or thousands and thousands of different individual stocks.

Now, this difference between indexes and individual stocks is referred to as systematic risk and unsystematic risk in the academic ranks of finance. Now, keep in mind that these labels are a lot more theoretical than they are practical, so for us as traders, we need to slow ourselves down a bit before we attach too much weight to what we have here. But nevertheless, these are very, very useful when it comes to understanding the differences between indexes and individual stocks.

Now, systematic risk, or market risk, is the risk that is inherent in simply having some capital at stake in the financial markets. It is unavoidable, and in many ways, it's simply a cost of doing business. Now, unsystematic risk, or single stock risk, is very different; this is going to be risks that are unique or individual to that one specific stock.

Therefore, they are avoidable, and they only become relevant if you happen to have a position on in that particular equity. All right, easy enough? Well, let's dive in a little bit deeper and work through some examples of each one of these guys.

So, starting with market risk, some common examples would be economic data, global growth or lack thereof, or maybe interest rates. Obviously, these numbers can have varying impacts and hit some indexes more significantly than others, but the idea is still that these risks are spread over the different stocks that make up the index. Now, single stock risk is a little bit different, with some common examples being an earnings report, maybe a product or service success or failure, or really any major company news.

These are only going to impact one or a small group of stocks significantly, while any stocks that are not directly impacted or related to these events are just going to go on with business as usual. Therefore, by focusing on indexes first, before you dive into individual stocks, you are only going to be exposed to market risk. So then, by definition, as a result of that, you are naturally going to have—or you can expect to have—a much smoother ride from start to finish.

All right, fair? Enough, but you might now be asking, "Jim, which indexes should I focus on? " Well, let's have a look.

Let's think about the indexes in three different levels. Now, these aren't formal or official levels; they're really just for us, but I think it will help to demarcate between the different kinds of indexes. So, Level One: these are going to be your major equity players: SPY (the S&P 500), QQQ (the NASDAQ), IWM (the Russell 2000), and DIA (the Diamonds or the Dow Jones).

Level Two: these are going to be your major non-equity players, like GLD (which is gold), TLT (which is bonds), USO (which is oil), and SLV (which is silver). And then lastly, Level Three: these could be considered your international indexes or maybe your sector indexes, like EWZ (which is Brazil) and FXI (which is China), and then XLE and XLU, along with a number of other X indexes that represent different sectors in the U. S.

economy. Now, of course, this was not an exhaustive list. It was intended to represent every single index that you could potentially trade, but I do think it's a reasonable starting point.

Now that you have this lean on this list, use this list and turn to all the strategies and the tools that you already have in your back pocket when it comes to stock screening, strategy selection, or trade entry. And if you don't happen to have any tools or strategies in your back pocket, then hey, let me offer up a shameless plug for our very first crash course from last fall that will help you do exactly that. Wow, so believe it or not, you already made it to the end of episode number two inside of this crash course!

Some of you, at this point, however, might be thinking, "Jim, wait a minute! What if I don't see enough opportunities with indexes? What if I don't see enough opportunities with indexes to hit my portfolio's Theta or portfolio's Delta goals—the very same goals that you showed me how to do back in episode one?

" You know, guys, it's almost like I've done this before because I had a sneaking suspicion that you might have that question. So, I suppose I will see you in episode number three, adding individual stocks. We are going to focus on the role that individual stocks are going to play in your portfolio.

To this point, we've already built up a decent little foundation. Right? Episode number one, we talked about our portfolio targets; episode number two, we talked about the power of using indexes.

Well, now it's time to layer in some individual stocks. So, without further ado, let's do it, man! Let's dive right into episode number three: adding individual stocks.

As we kind of alluded to on our way out the door back in episode number two, there's a really good chance that indexes are not going to be enough. There's a really good chance that for you to hit your portfolio targets in Theta and Delta, you are going to need some individual stock exposure. That makes sense.

But before we do this, let's make sure that we all understand it—we all remember what it is that we've signed up for as premium sellers. When you sell an option (which is what we primarily do), you want its price to fall over time so that you can buy it back later at a lower price. Doing this would lead to a profit that is really no different from buying stock or buying an option, letting its price increase, and then selling it later at a gain.

Selling the option first is just this process in reverse. But even more specifically, we primarily sell out-of-the-money options, so their prices are 100% extrinsic value. Over time, these extrinsic values will naturally be falling as an out-of-the-money option must sell for zero at expiration.

So, we want to benefit from this with our new positions as premium sellers. Okay, so now that we're all on the same page in terms of what we're even trying to accomplish, it's going to be easier to see the power that individual stocks can play—the role that they can have in your portfolio. If we take a look at one of the most important metrics that we use at Tastytrade: implied volatility rank.

Implied volatility rank, or IVR, is a metric that we lean on heavily, and it shows quite literally how the implied volatility for a stock stacks up against its historical self. By taking the current implied volatility of the stock in the numerator and dividing it by the previous year's range in implied volatility in the denominator, we're able to more accurately gauge where implied volatility is right now relative to where it has been. For example, let's say that last year's implied volatility range ranged from 10 on the low end to 35 on the high end.

If the implied volatility right now is at 15, then the implied volatility rank is going to be sitting at 20. The implied volatility is 20% into the distribution of all the implied volatilities from the last 12 months. Similarly, let's say that the implied volatility were at 30 based on last year's range of 10 on the low end to 35 on the high end.

Now the implied volatility is 80% into its distribution or range from the last 12 months, so this would lead to an IVR of 80. Okay, all that stuff about IVR—that's all well and good—but why is this important? Let's look at a couple of different reasons.

First off, and quite simply, a higher implied volatility rank means higher option prices since higher IVR can only happen from higher IV itself. Higher IVs, in the Black-Scholes model, lead to higher option prices out of the model. IVRs are going to lift option prices.

This is helpful because, remember what we've signed up for, guys? We want option prices to fall over time, so if we can sell them for a higher price, ceteris paribus, then we automatically have more room to work with on the backside. But second, volatility is a unique metric in that it tends to mean-revert over time.

This means that volatility expansion is often followed by volatility contraction, and vice versa. Therefore, entering positions with higher IVRs can put us in a more favorable position to benefit from volatility mean reversion. A word of caution here, though: while volatility has been reliably shown to mean-revert, we never know when it's going to happen.

It can remain extended longer than we can hold on. All right, Jim, I have to admit, man, a couple of minutes in, and you've sold me on this high IVR situation. So, where can I find some high IVR opportunities?

Well, let me give you two really good resources. First up, the pre-populated watch lists on the platform are excellent tools to start with. The default watch list or even Tom's watch list will give you a pre-screened list of all the stocks you see us trading day in and day out.

Sort these watch lists by IVR, and you will be in business. But second, earnings! Earnings for publicly traded companies come around every three months, and generally speaking, earnings tend to lift the IVs or the IVRs of stocks as traders bid up option prices in anticipation of potentially explosive moves.

Thus, these are a great time to establish new short premium positions. Just be careful, as these big moves can make earnings a tougher go than more regular trades, but it's still worthwhile to check these out to see if anything jumps out at you. Now, again, use indexes first, right?

Like, lean on what we talked about back in episode number two and use the indexes to begin to populate your portfolio. But there's a really good chance that you're not going to get to your portfolio targets with indexes alone, so this is when individual stocks come into play. Now, naturally, some of you—all of you, especially you beginner traders out there—are thinking at this point, like, "All right, Jim, you nudged me in the right direction when it comes to implied volatility and individual stocks, but man, you left a lot to be desired when it comes to the specifics, when it comes to the strategic detail around how to actually execute these trades.

" That is 100% correct, and the reason why I did leave a lot to be desired here is to go back to crash course number one and crash course number two, both of which are already available on our YouTube channel, and we went through all of that in very, very fine detail. So be sure to give those guys a look if you haven't done so already. And man, just like that—almost like it didn't even happen—episode number three of the How to Build the Portfolio Crash Course has come to its natural conclusion.

I will see you in the final segment inside of this crash course, episode number four: the day-to-day management of your portfolio. We've already talked about your portfolio targets; we've talked about using indexes; we've talked about adding individual stocks. Here in episode number four, we're going to talk about arguably the most important part: the day-to-day management.

My hope is that after this episode, you guys will begin to see how everything comes together. So let’s do it, man! Let’s dive right in to episode number four of the How to Build a Portfolio Crash Course: the day-to-day management.

All right, so the day-to-day management really boils down to one singular thing: you need to identify problems. If your strategies are working, doing nothing is almost always going to be the move. Like, if things are going well, sitting on your hands and unplugging your mouse is almost always going to be in order.

But naturally, there are going to be times—maybe on a daily, maybe on a bi-daily basis—where things might not be going as swimmingly as you might have hoped. So here, you need to identify the problems, and specifically, you need to differentiate between problems at the position level and problems at the portfolio level. So, position-level problems, these are usually going to be pretty obvious, like they’re going to jump off the screen and stick out like a sore thumb.

They could be a huge move in the stock, could be a situation where one of your strikes has been breached, or maybe you've just naturally reached the 21-day marker in that cycle. Sure, some of these are going to be a bit more surreptitious, like, you know, your index individual stock exposure, but usually, you won't have to go hunting around to find these guys; they’re going to find you. Now with your portfolio-level problems, these should also be fairly clear, mainly because you took the time to establish your portfolio targets at the very beginning.

Are you too directional? Do you have enough theta working for you? Do you have too much theta working for you?

These are all going to be common questions that you're going to find yourself asking as you are viewing your portfolio. Knowing what you're trying to accomplish with your delta and with your theta will allow you to see very easily when things are off target. Okay, so now that we've got our bearings set and we know what it is we're even trying to accomplish when it comes to day-to-day management, let’s dive deeper back into the position level.

First off, it's important to mention that we've already built an entire. . .

Crash course around strategy management with the ins and outs of how to adjust our most popular strategies. So I'm not going to regurgitate that here; instead, I want to offer more of a bird's-eye view of your portfolio as it pertains to defined risk strategies and undefined risk strategies. Okay, so starting off with your defined risk strategies: these are going to be, you know, your short put spreads, your short call spreads, your iron condors, etc.

These are going to be pretty hands-off, a lot more affair where you just let the trade go and you give the probabilities room to breathe. Either you take the trade off at your profit target, or you end up absorbing a loss. Now, could you adjust these?

Sometimes, yes, but that's more of an in-depth discussion that we're not going to have here because if we did, I would be front-running myself before the next crash course that is slated to follow this one, so stay tuned for that. Now, with your undefined risk strategies, you know, your short puts, your strangles, your ratios, etc. , this is where all the subtlety and nuance is going to start to show up.

Right? Any adjustment wizardry or management magic is almost always going to materialize with naked positions. Now again, check out the strategy management series for more of the tactical moves that you would actually make; but generally speaking, from a problem identification standpoint (which is our goal here, remember), it's pretty simple: if you're out of the money, you do nothing.

Once your strike is hit and things move in the money, that's when you act. If you're before 21 days to go, you do nothing. Once you get to 21 days to go, then it's time to move.

Then it's time to act. All right, so those are the frontline actions that you're going to want to take at the position level, which I would argue should be addressed first, if for no other reason than these guys are usually going to be very, very obvious. But still, we have some portfolio-level problems that need to be addressed, so let's have a look.

Once all of your individual positions have been taken care of and any and all necessary adjustments have been made, here you turn to your overall portfolio. At the same time, it might not be a terrible idea that, as you're making the necessary position adjustments, you have an eye on your portfolio targets. That way, when it's a close call as to what you should do, kind of a toss-up either way, you can defer to those portfolio targets.

But if there's ever a disagreement between the portfolio level and the position level, then the position level pulls rank. Like, for example, let's say you need bullish deltas at the portfolio level, but a given position is far too bullish and you need to add some bearish deltas to balance it out. Here, you want to let the position level be your guide first and foremost.

The reason why is that there is only one way to adjust a given position's situation: it's through that given position. But with your portfolio as a whole, you can always find new trades and establish new positions to adjust your overall levels too. Then, once each position has been adjusted, you can look to add new positions to adjust your overall portfolio goals, which is pretty straightforward.

You need positive delta; you add trades with a bullish bias. You need more positive theta; you add trades with positive theta, probably of the undefined risk nature, so that you can build up theta more quickly. If you have too much positive theta, hey, you can close some of your existing trades, also probably undefined risk, or you can add new trades that are more defined risk, so their theta impact won't be too significant.

A couple of things to keep in mind moving forward with this information: number one, don't feel like you need to nail your portfolio targets every single day. If they're off just a little bit and it takes you a couple of days to bring these things in line, it's unlikely that that's going to be a real big issue. But number two, at the position level, you should be able to achieve your desired outcome in terms of directional bias, in terms of theta, in terms of whatever it is you're trying to accomplish with that one specific position.

You should be able to do that in the moment; you should be able to do that in the here and now. It shouldn't take too long for you to course-correct that one individual position. Wow!

And just like that, ladies and gentlemen, we are done. We are done with episode number four. We are done with the entire crash course!

I really hope this gave you guys some new ideas, and when you are ready, I will see you in the next crash course, which I don't know when it's going to be ready, but when it is, I hope I'll see you there.