The cornerstone of diversification used to be the 60/40 portfolio, a set of assets divided into 60% stocks and 40% bonds. However, this traditional balance is under pressure from today’s markets, where there’s a rising correlation between fixed income and equities. How have the traders of today pivoted their strategy to ensure that their portfolio construction is well-balanced?
There’s a portfolio design philosophy known as “risk parity” that equalizes risk across multiple asset classes instead of having that risk allocated by capital weight. Traders can join the forces or risk parity with the flexibility of options strategies to develop the framework of their portfolio beyond the traditional 60/40 split that was so common all those years ago. Using options with a risk parity portfolio lets traders build exposures that work well with changing macro regimes and hedge tail risk.
Keep reading to learn more about risk parity and how you can develop a robust portfolio of investments that goes beyond just stocks and bonds for much better diversification.
Risk Parity Explained
Risk parity was originally popularized by the “All Weather” portfolio by Bridgewater, and the idea gained a lot of attention and popularity because it delivered smoother performance for portfolios across various market regimes. The core concept behind the idea was equalizing risk contributions across assets, rather than dollar weighting. No single asset class should disproportionately drive portfolio risk.
Then you have the typical 60/40 portfolio of yesteryear, which has equity dominating the overall risk exposure due to the higher volatilities. However, risk parity balances these risk contributions through better asset allocation and not just focusing on capital allocation. The risk spreads move evenly across multiple asset classes, including bonds, commodities, equities, and the like.
Why Traditional Risk Parity Needs Options—Options for Risk Parity
When you’re taking a close look at traditional risk parity, you’ll see that it relies heavily on equities, commodities, and bonds, which can create some significant challenges when you look at the modern-day context. Some of these problems with the 60/40 distribution include the following:
- Problem 1: Bonds no longer provide reliable diversification (low yields, high correlation). They don’t serve as reliable hedges like they once used to, and a lot of this has to do with the persistently low yields and the higher equity correlation during inflationary periods.
- Problem 2: Pure equities dominate portfolio risk even when weighted less. Even if you’re faced with reduced allocations, stocks generally contribute to 80% or more of all portfolio volatility. Having 60% of your investments riding on stocks simply doesn’t fly in today’s trading environment.
- Problem 3: There is also the issue of limited convexity, where traditional asset classes cannot capture asymmetric payoffs.
Using options as portfolio diversifiers can replicate bond-like exposures, hedge equity drawdowns, or add convexity. Options ultimately solve these challenges discussed above. By introducing protective puts, covered calls, volatility spreads, and index options, investors can engineer exposures that mimic or improve upon the diversification bonds once provided.
Building Blocks—How Options Fit into a Risk Parity Portfolio
Using these tools or building blocks goes a long way toward expanding the risk palette—it allows investors to enjoy more levers than just adjusting weights between stocks and bonds.
- Protective Puts: Hedging downside risk in equities is what using a protective put strategy ultimately accomplishes. Stock allocations become far less volatile, and it has the ability to align risk correctly with other assets.
- Covered Calls: This options trading strategy can help traders to harvest premium income, which helps out with smoothing returns and offsetting volatility drag. The covered call is a good way for traders to generate income and balance equity volatility.
- Index Options: Traders can scale exposures with more flexibility than through buying ETFs by focusing on options on the S&P 500, Nasdaq, or Russell 2000. These indices have a way of scaling exposures back.
- Calendar & Diagonal Spreads: Using either of these spreads can help traders manage volatility and time decay to replicate the stability that bonds once offered. These spreads can provide steady carry while replicating the defensive characteristics of fixed income.
- Volatility Products: To achieve tail-risk protection, traders can use options on the VIX or volatility ETFs, which ultimately ensure the portfolio holds up during crises.
Example Portfolio Construction—Sample Risk Parity with Options Portfolio
Now let’s take a look at how you can construct your online portfolio in the current-day market context and do so in a way that offers a diversification edge. Instead of using the traditional 60/40 setup that used to be a lot more common, traders today should be using the following hypothetical risk parity portfolio mix:
- 40% Equities: Traders can use protective puts to cap the potential downside risks associated with these assets.
- 30% Commodities: If traders are dealing with broad commodity EFTs or straight-up commodity options based on gold or oil, they can be using call spreads to capture upside down to inflationary pressures.
- 20% Volatility Strategies: Tail hedges can be established by using VIX call spreads or S&P 500 put spreads. These volatility plays should only make up about 20% of the portfolio holdings.
- 10% Cash or Treasuries: Traders need to hold about 10% of their portfolio in cash or treasuries for the purposes of liquidity or collateral.
Portfolios can adapt to different regimes, be it inflation, deflation, or stagflation. Instead of equities dominating risk, options, along with risk parity, can combine forces to help traders equalize contributions. Puts flatten equity volatility, and on the other hand, commodity and volatility exposures step up to spread the load evenly. The ultimate result with this approach and distribution of assets is a more balanced portfolio across growth, inflation, and crisis environments.
Benefits of Using Options in Risk Parity
What are some of the best perks of using options in the process of achieving risk parity? We’ve outlined them below to show how you can develop a well-diversified portfolio that can stand up against multiple market risks. Remember that true diversification is beyond simply focusing on bonds and stocks, as was the case in the olden days.
- Non-Linear Payoffs—You’ll experience asymmetrical returns when you’re dealing with convex strategies like protective puts or VIX calls. This ultimately leads to non-linear payoffs.
- True Diversification—Delving into investments that go well beyond stocks and bonds can help diversify your portfolio to the point where your investments are well-hedged and protected against adverse market movements.
- Good Risk Management: Using risk parity can help out traders by letting them adjust the vega, delta, and gamma exposures, instead of shifting core allocation.
- Better Risk-Adjusted Returns: When you’re using an options-based risk parity portfolio, you can begin enjoying an improved risk-adjusted return that goes to great lengths to increase the Sharpe ratio and smooth the equity curve.
Perhaps the biggest benefit involved with using options trading strategies alongside risk parity is the ability to dial risk exposure dynamically without shifting core capital allocations.
Pitfalls and Considerations—Risks of Risk Parity with Options
Risk parity and using the approach with trading options come with a wide array of risks and pitfalls, which should give traders some pause as they move forward with these strategies and techniques. Options-based risk parity is a powerful tool, but it comes with some unique challenges and risks that any newbie trader should know ahead of time before using it.
- Complexity and Learning Curve—Traders need to have a good understanding of the Greek symbols and how they work, as well as the ability to conduct active management with these positions to see them through to a profitable end.
- Liquidity Risk in Certain Markets—Some options markets can be thin, such as commodities and volatility products. These options can be harder to trade quickly and at a fair price that doesn’t affect the underlying asset too much.
- Cost of Hedging—If they aren’t timed right or structured well, protective strategies tend to drag returns—it’s what’s known as the “cost of hedging.”
- Importance of Rebalancing and Position Sizing—For risk parity to be a success for the options trader, it is key for continual adjustments to occur as the market volatility shifts. It’s also important to keep a more conservative position size to ensure good risk management.
- Regulatory and Margin Considerations—Collateral requirements could hypothetically increase due to options overlays. Successful implementation means weighing these costs against the diversification benefits.
Advanced Strategies for Risk Parity with Options
Advanced traders can leverage the power of advanced overlays by following these advanced strategies for risk parity with options. These setups go a long way toward investors being able to build portfolios for the modern era that are “all-weather,” standing up to the modern-day market demands and pressures.
- Volatility targeting: Traders can use options flow for allocation adjustments, but they can also use the same purpose for volatility targeting. It’s done through adjusting option exposures dynamically to maintain consistent portfolio risk.
- Tail-Hedging: Using overlays that are composed of long-dated puts or VIX calls as insurance against systemic shocks can help traders to use risk parity with options for an additional layer of protection.
- LEAPS: Another good, advanced strategy is leveraging LEAPS for long-term convexity. Long-term options create convex exposures without constant rolling, which provides a big incentive for traders who are looking to take portfolio diversification to the next level.
- Crypto & Commodity Options: Combining options with these alternative assets can add plenty of diversification beyond traditional assets of stocks and bonds. This helps to develop the “all-weather” portfolio that most modern investors hope to attain.
Key Takeaways
Risk parity is evolving beyond the stock-bond framework—it’s a more sound framework for getting a truly diversified portfolio. We would love to say that stocks and bonds are enough to keep present-day traders afloat, but that is far from the case. Options provide flexibility, hedging, and diversification tools unmatched by traditional assets. Combining them with risk parity strategies can help traders develop smarter risk-balanced portfolios.
A good place to begin is with strategies like covered calls, protective puts, volatility options, and index spreads. Practicing these moves ahead of time using paper trading simulators is advisable, though, giving traders time to master this strategy’s nuances to have their portfolios thrive over inflationary, deflationary, and crisis-driven markets.
Explore more on options strategies for portfolio construction at OptionsTrading.org.
Frequently Asked Questions
Let’s take a look at some of the most common questions from our customers and readers regarding combining risk parity with options strategies. By digging into these questions and answers, you can gain some of the key insights discussed in this guide without having to read the entire thing.
What Is a Risk Parity Portfolio?
A risk parity portfolio balances risk contributions across asset classes instead of weighting by capital. This approach smooths performance across different market environments.
What Are the Risks of Using Options in Risk Parity?
Options introduce complexity, potential liquidity issues, and hedging costs. Active management and rebalancing are required for long-term success.
Is Risk Parity Better than a 60/40 Portfolio?
Risk parity often provides more balanced outcomes across inflation, recession, and growth regimes compared to the traditional 60/40. With options overlays, it can be even more resilient.
Can Options Improve a Risk Parity Strategy?
Yes. Options provide convexity, hedging, and dynamic exposures that help equalize risk contributions, especially as stocks and bonds move more closely together.
