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How Options May Diversify a Single-Asset Portfolio

Article Quant Q&A · Author: Nikolay Rys
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Summary

The document asks whether combining a volatile underlying asset with options can improve portfolio diversification, measured by a higher Sharpe ratio than holding the asset alone. It motivates the question with a position consisting of one share and one short out-of-the-money call: the option premium may respond differently from the underlying’s kinked combined payoff, potentially changing the portfolio’s return pattern.

It also raises a broader question about adding options to portfolios containing many assets. The text does not provide data, a calculation, or a conclusion, so it presents a hypothesis rather than evidence that options improve Sharpe ratios. Any assessment would depend on option pricing, payoffs, portfolio weights, and risks such as losses when the underlying rises sharply; the example alone does not establish a diversification benefit.

Key ideas

  • The proposed test compares the Sharpe ratio of an underlying-only portfolio with one that also holds options.
  • A short out-of-the-money call changes the payoff of a share-and-option position.
  • Different payoff responses could alter portfolio returns, but the document provides no empirical test.
  • Whether options improve diversification in a multi-asset portfolio remains an open question in the text.

Tags

OptionsPortfolio constructionRisk management
Full text
# Do options have diversification benefit?


# Do options have diversification benefit?












Imagine the universe where we have one investable volatile asset but with an available liquid options chain for it.

The question: can a portfolio consisted of this asset, and some options have any diversification benefit(higher Sharpe ratio) comparing to a portfolio with just the underlying?

At face value, it should; take an example of a portfolio consisting of the 1 share of the underlying and 1 shorted out-of-money call option contract. The payoff of the option part(option premium) doesn't correlate much with the payoff of the now-kinked payoff of the underlying.

Bonus question: If the answer is yes, then in the real world with many investable assets, will adding options into a portfolio be able to improve its Sharpe ratio?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.