The top-down approach to the financial markets is one of the techniques traders assess to determine a few different things that are vital to the health and stability of his portfolio. Remember, the portfolio is always more important than an individual trade.
Oftentimes, however, we get so caught up in one trade that we get away from what we’re trying to accomplish in terms of controlling and managing our money.
Have a game plan
Like a good coach in a football game, traders prepare for the game of trading. This game is cutthroat, nasty, brutish, zero-sum, leave the children at home, and you should get ready to play rough.
It’s also a game I absolutely love, and one that, if we prepare like a good coach, we’ll be successful in playing. The list of preparation we go through is enormous from start to finish, and I will go through all of it in time. However, the thing I want to discuss in this post is that of portfolio design and bias.
Delta Weighting a Portfolio
As a trader, I truly don’t care if the markets go up or down. However, as a delta trader, I obviously care that they go in my direction. Regarding the portfolio, the first thing I need to determine is the balance, ratio, or weight of the portfolio. This is a concept called delta weighting. It simply means the balance of bullish to bearish trades by percentage in a portfolio. Delta weighting a portfolio is an advanced topic, but one thing the coaches at Tackle Trading specialize in is taking the difficult and teaching it in simple terms that all traders can understand.
For example: if I have a $100,000 portfolio and I am neutral in the markets, it makes ZERO sense to have all bullish positions in the portfolio. However, that is exactly what all the mutual fund zombies are doing.
It makes more sense to allocate some type of neutral balance such as $50,000 in bullish trades and $50,000 in bearish trades. Or, alternatively, you could allocate about $25,000 in bullish trades, $25,000 in bearish trades, with some in commodities and currencies, and some collecting dust on the sideline waiting to strap the helmet on to help either the bullish or bearish team? Regardless of the balance, I think you get the idea. You need to build a portfolio that reflects your market opinion, which we also call market bias.
To determine the weight of the delta in a portfolio, we must first determine our bias in the market. Market bias is nothing but which direction you assess the market to be going in the future. There are three main biases in the market.
In breaking down the market bias, we look at a number system between -3 and +3. The larger the number, either positive or negative the more aggressive your bias is. So, if you believe the market is going to skyrocket to the upside you would rank your bias a +2 or +3. If you are bullish, but believe the trend is casual, consistent and nothing extra-ordinary, you might rate your market bias +1.
If you are aggressively bearish, you would give your market bias a -3 or -2. If you believe the market is bearish but only slightly or consistently selling off, then a ranking of -1 would make sense. If you are neutral, your rating would be 0.
Start with the S&P 500 Index
Now that we have that down, let’s look at the SPX which is typically down on weekly charts to smooth out the daily movement and get a clearer picture of what is really happening in the market. I do this mostly on the daily chart, but what I’ve found is the over bias shifts too much, and we lack the consistency that is needed for the health of the portfolio in the long run.
Your bias should reflect the trend of the market, and your anticipation of where prices are going to move over time. Your bias is not a daily report card. It is about the next few weeks to few months of anticipated price action. If the trend of the market is bullish, and increasing momentum, with high volume and lots of good news, your bias will be a +2, for example. If the trend is bullish, but momentum is slowing or stalled, you can still rate it a +1 if you believe prices will rise over time.
The most important thing in assessing our bias is the trend of the market. The old adage in the market is the trend is your friend. It’s an adage for a reason. This is clearly a bullish uptrend, but on the far right-hand side, you are seeing some slowing momentum which the first sign that the trend is over.
Due to the slowing momentum, my market bias would be in the +1 range. However, after I analyze the SPX, I look at other factors such as sector strength, the other indexes, flight to safety money flow, market cycles, geopolitical concerns, and potentially other types of analysis to determine if there is something out there that would justify moving the bias up to +2 or down to 0. There is absolutely nothing that will have me shift more than one movement from the trend which is +1.
At Tackle Trading, we recommend that you track your bias regularly either daily, bi-weekly or weekly. Your bias should not change radically from one extreme to another. It should move gradually up or down as the markets change their pattern and or trends over time.
Sector Rotation
After you look at the overall market charts like the S&P 500, it is wise to work your way down in your top down analysis and then look at sectors.
Within the SPX, there are 9 sectors, and some of these are aggressive while others are defensive. What makes a sector aggressive or defensive goes to the heart of the most predictable and thus most taken advantage of market participant: the consumer.
Consumer spending accounts for 70% of the $16 trillion United States GDP. When consumers have a job, their 401k is going up (although not even remotely close to what it should), they’re happy, not worried, and everything is grand in their own world. They do one thing with their money: they spend. They live paycheck to paycheck regardless of how large or little it may be, and they spend. They upgrade their vehicle when they just bought their previous one a year ago. They spend and then they spend more. This mindset has a direct impact on companies that benefit from an increase in consumer and government spending, and these companies are in aggressive sectors which outperform defensive sectors when the markets go up.
Aggressive Sectors
Below are the following sectors with their symbols:
- Industrial (XLI)
- Technology (XLK)
- Basic Materials (XLB)
- Energy (XLE)
- Consumer discretionary (XLY)
Defensive Sectors
This type of sector will underperform the aggressive sectors in bull markets but are safer due to them being part of the flight to safety when the markets get concerned, as well as these items being things consumer spend money on regardless of their own personal fear. For example, regardless of anything, we take our kids to the doctor, we pay our mortgage (ideally), we put food on the table, and keep the house warm during the winter.
- Health Care (XLV)
- Consumer Staples (XLP)
- Financial (XLF)
- Utilities (XLU)
The Gridiron
Each weekend, the Tackle Trading coaches rank the market and sectors and post the ratings on the Gridiron in the Tackle Trading Newsletter.
As you can see, most sectors currently have a +1 slightly bullish rating. So it would make sense to keep my current market posture on the overall market at +1 as well. I will also look at raw sector performance to better understand strength or weakness, and sector rotation.
Sector Performance
When markets are strong and bullish, you tend to see prices in aggressive sectors performing the best. Between December 31st, 2019 and July 17th, 2019, the S&P 500 rose 19.05% and the Technology sector was up +30.66% during that period. During the same stretch, a defensive sector Health Care only rose +7.43%, which still was up, but underperformed the market and underperformed the aggressive sectors in the market. Knowing that the more aggressive sectors are in stronger trends and performing better, it gives more clarity for our market bias and re-affirms a bullish bias at +1, for example.
Bringing it all Together
After you’ve conducted your broad market analysis, looked at all the key index charts, sector charts and other indicators that you use in your own analysis, you still must give your final rating for the period you’re reviewing. What is your market bias? What is your rating? In the examples above, a rating of +1 would be appropriate.
What does this mean for the portfolio? The simple answer is everything. Delta weighting is one of the most important concepts you’ll learn as a trader. Delta helps us understand the weight or balance of the directional bias in the portfolio. Due to my bias being neutral, I want to carry a neutral delta. It’s the first number I look at in the morning when I start my daily routine (hobby traders look at P/L; pros look at theta and delta).
While it certainly is an advanced concept, the initial understanding of the math behind it is quite simple:
Delta Weighting Calculations
Portfolio Size x Number = Delta
(based on 100,000 Portfolio to make it easy)
› +2 = 100,000 x .07 = 400 to 700 delta
› +1 = 100,000 x .04 = 100 to 400 delta
› 0 = 100,000 x .01 = 100 to –100 delta
› -1 = 100,000 x –.04 = –100 to -400 delta
› -2 = 100,000 x –.07 = –400 to –700 delta
In the example above you see a table of how much beta weighted delta would be appropriate if you had a $100,000 portfolio and you had beta weighted your portfolio against the SPY. There is a calculator in the Tackle Portfolio Spreadsheet journal, on the second tab of the excel spreadsheet that you can use to create numbers for your own portfolio. If you don’t have a copy of that journal, get one here.
Based on the examples above, and with my market bias, I need to end the trading day with a delta in the 100 to 400 range to ensure that my market bias and portfolio bias are in the same range. Below are some trades I made in a virtual trader in class a couple of days ago.
As you can see, the delta is in line with my market bias. If the delta was off, it would tell me what trades I need to pull off or add to the portfolio. Delta makes our lives easy as a trader as it tells us what we need to look for daily as we manage our accounts.
Summary
Starting at the top of the markets, working through your accounts and building your portfolio’s by design are all important steps in top down analysis. Using tools like Beta Weighting will allow you to ensure your portfolio design stays in line with your market bias. As your market bias changes and your opinions about what will happen next changes you can then adjust your accounts by either exiting some trades or adding new trades to adjust your portfolio delta.
Supplemental video: How to delta weight your portfolio
In this video, Coach Matt talks about the craziness the news media can bring to trading and asks Coach Noah to explain how traders can protect themselves from this. Noah then explain the important concept of delta weighing a portfolio.
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8 Replies to “Delta Weighting Portfolio: Determining portfolio bias based on Delta”
very informative @matt
Exactly what I’m trying to get a handle on, Matt. Thanks so much!
you are more than welcome. It is a concept and technique that is vital as the market continues to act like a 5 year throw a temper tantrum
Thanks Matt. As a new trader, your explanation is simple and easy to understand. I should get a handle on this in no time. Makes sense.
Excellent Article
Thanks Matt, very enlightening!
Matt,
Great article! Delta and Theta weighting are fairly recent concepts for me, but I am already starting to realize how much I was missing without them.
How do bullish trades on defensive sectors fit into the delta weighting adjustment you described?
If I were to open a few long call positions on defensive sectors for instance, I am presuming my portfolio delta would go up. At first glance, it would seem I am biasing more to the bullish side, but the stock selection is more in line with a shift to a neutral portfolio. Is this the right assessment?
Thanks again for the article! @matt
I love this concept very much, thanks for sharing Matt : )
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