One of the central tenets of the Options Animal methodology is that each trader must trade his or her personality. Some people are more aggressive, some conservative. Some are more patient, and some people thrive on the thrill of immediate results. Then, there are some, like me, who seem to have multiple trading personalities. A trader who tries to fight his or her inner nature will likely fail. Sometimes that means sacrificing possible returns in order to have the comfort level to trade without fear. I would like to share how I have adapted a time worn methodology of portfolio management to help me accommodate my own unique psychological needs.
The “bucket” method of portfolio management is a strategy designed to help investors maintain the right mix of cash, stocks and bonds to fund their needs over varying time frames. It is often discussed in reference to retirement planning. For example, a person about to enter retirement might have three separate portfolios – one consisting of a combination of cash and short term cash alternatives designed to fund his living expenses for a set number of years, a second portfolio with a mix of high grade bonds designed to be used in the intermediate term and a portfolio with a mix of equities designed to generate growth going forward. There are, of course, innumerable variations of this methodology, but the general idea is to allow an investor to have sufficient cash to fund her immediate needs while still allowing for the superior growth usually (but not always) afforded by equities.
The downside of this strategy is that in many, if not most market scenarios, the large amount of money set aside as cash will cause the combined portfolio to underperform. The upside is the security provided by the knowledge that if we experience another major bear market, the investor has the cash to withstand it without having to sell stocks at depressed levels to fund his living expenses. In my view, the psychological buffer is even more important than the actual financial buffer provided by the cash. Anything that will help keep an investor steady and prevent panic selling will likely lead to increased returns despite the drag provided by the cash.
I use a variation of the bucket method designed to work with my unique personality as an options trader. Similar to the standard method, I have three distinct buckets. Bucket number one serves the function of two of the standard buckets – cash and growth. As an options trader, I do not need to rely on a basket of securities to provide my growth. I can generate it through my options trading and do it with a healthy cash reserve. That is the beauty of trading the way we do. I am fairly conservative in that portfolio, rarely risking more than 1/3 of the funds at any one time. Usually, I risk quite a bit less. In exchange for that margin of safety, I gladly give up a portion of my possible return. The large cash buffer serves the same function for me as it does in the standard method. I know I have the cash to use if I need it, and it prevents me from panicking out of trades when things do not go as planned. So, although theoretically, being conservative may reduce my returns, ultimately it makes me a more confident trader which in turn, increases my actual returns.
Bucket number two addresses a different element of my personality: the need to be speculative and aggressive. There is a part of me that really loves the speculative trades that hold out the promise of large or quick returns. There is a thrill to that kind of trading and an intellectual challenge as well. Playing on the speculative side makes trading interesting and enjoyable for me. Originally, I used a portion of my main portfolio for these trades, but I was tempted to use an increasing percentage of the portfolio to fund them. The two styles were interfering with each other. I created a completely separate portfolio for the aggressive trades. I only fund it with money that I am willing to lose. I only allow myself to add a limited amount to it each year, and I know that if that money disappears, it will not affect our lives in a meaningful way. Limiting the funds may limit my trading opportunities, but again, it makes me a more confident and, therefore, a more successful trader.
Finally, bucket number three addresses a completely different fear – not the fear of losing in a downturn, but the fear of missing out on large market run-ups. My main portfolio is always hedged. The nature of hedging means that in strongly bullish markets, I will underperform. As I said, it is a tradeoff that I am willing to take. However, too often, I watched the market race ahead without me and was tempted to doubt my choices or worse turn winning trades into losers in an attempt to chase the market. To solve this problem, I filled my third bucket with shares of the exchange traded fund, SPY. SPY tracks the returns of the S&P 500. I don’t often do options trades around those shares. For the most part, I just let them sit and grow over time. Like the most boring of buy and hold investors, I try to add to it every month. Having this portfolio has a calming effect on me. When we have extended bullish runs, I know that I am participating regardless of what I am doing in my other accounts. During bearish times, I am buying in at lower prices. Unlike with individual equities, I have no fear that the SPY will go bankrupt. I have enough years ahead to wait for the inevitable recovery. I do use options techniques occasionally to increase the returns, but the main goal of that bucket is to let me participate in the market without effort so that I can focus on the accounts that really need my attention.
In sum, three buckets fulfill the needs of all my various personalities and let me be the best trader that I can be.