“The goal of a successful trader is to make the best trades. Money is secondary”
- Alexander Elder
Trading is a journey full of learning opportunities, and many traders often wish they knew back then what they know now. As someone who has been on this journey for over a decade, I've learned that in trading, one must always be a student, never the master. In this article, I'll share insights on trading around a core position, a strategy I wish I had known from the start.
Understanding a Core Position
A core position in trading is a primary asset that serves as the foundation of your portfolio. It's typically a stable, well-researched investment that you hold for the long term. The importance of a core position lies in its ability to provide stability and potential growth, serving as a reliable anchor amidst market fluctuations. For example, holding a strong tech stock like Apple as a core position can provide a base from which to make other trades.
The Concept of Trading Around a Core Position
Trading around a core position involves making strategic trades around your core asset to capitalize on market opportunities. This strategy helps manage risk and maximize profit without compromising the stability of your core position. By doing so, you can protect your core investment while taking advantage of short-term market movements. In my experience, this approach has allowed me to balance risk and reward effectively, leading to more consistent trading success.
Steps to Establish and Manage a Core Position
Identify a Strong Core Asset: Look for assets with strong fundamentals, growth potential, and stability. Conduct thorough research to ensure it fits your long-term goals.
Initial Investment: Make an informed decision on how much to invest initially. This should be a significant, but not overwhelming, portion of your portfolio.
Monitoring and Adjusting: Regularly review your core position. Adjust by buying more when the asset is undervalued or selling portions during market peaks.
Using Technical and Fundamental Analysis: Employ both types of analysis to make informed decisions. Technical analysis helps with timing, while fundamental analysis ensures the long-term viability of your core asset.
Real-World Example: Trading Around a Core Position in Waste Management (WM)
Waste Management, Inc. (WM) has long been one of my core positions due to its stability, strong fundamentals, and consistent dividend yield of 1.42%. Let's explore how I trade options around my WM core position to enhance returns and reinvest profits.
Building a Core Position Using a Naked Put Strategy
I use a naked put strategy to build my core position in Waste Management (WM). For instance, I started my position by buying 200 shares at $52.50 per share back in January 2016. Now, I want to add another 200 shares. Rather than buying these additional shares at market price, I choose to sell 2 naked put contracts, giving me control over both the price and timing of my entry.
In this scenario, I'm comfortable owning an additional 100 shares of WM at $50 per share by the end of February and another 100 shares at $45 per share by the end of March. By the expiration of these contracts, one of two outcomes will occur:
Stock Price Above Strike Price: If the stock price remains above the strike price, the put options will expire worthless. I won't acquire the shares, but I keep the premium from selling the puts.
Stock Price Below Strike Price: If the stock price falls below the strike price, the put options will be exercised. This means I will purchase the shares at the strike price ($50 for the February contract and $45 for the March contract), effectively adding to my core position at my desired prices, and I still keep the premium from selling the puts.
This approach enhances my overall return and aligns with my long-term investment goals. If the stock price stays above the strike price and I do not acquire the shares, I keep the premium from selling the puts. I can then rinse and repeat this strategy, using the premium earned to buy more shares of WM.
Utilizing Covered Contracts to Grow Your Core Position
Another way to continue accumulating shares is through a simple passive income strategy using covered calls/puts, which allows me to maximize the value of the time I hold my core position. Since I'll be holding the shares anyway, I might as well profit from this period. For every 100 shares I hold, I can write one covered call or put contract.
To maximize the premium received and increase the likelihood that the contracts will not finish in the money, I employ a smart approach using technical analysis. This helps determine the optimal timing for writing these contracts, ensuring I get the best possible premiums while minimizing the chances of the options being exercised.
If the price is trading sideways in a consolidation range, I look to sell a covered call when the price is at the top of the range, either just in the money or slightly out of the money. At the bottom of the range, I write a covered put.
If the price is in an uptrend, I use a simple trend line or price channel to guide my strategy. I sell out-of-the-money covered puts when the price is at the low side of the channel or testing the trend line. In a downtrend, I apply the same strategy in reverse: I sell out-of-the-money calls when the price is at the top side of the price channel or testing the trend line.
The duration for which I sell these covered contracts depends on overall market conditions and whether the options are priced expensively or cheaply. Typically, I avoid going more than 60 days out. Additionally, if I notice I can make more money by selling weekly options each week rather than a single contract for the entire month, I opt for the weekly options.
Writing covered contracts is a strategy I use to trade around my core position and generate passive income, which I can then use to acquire more shares. This approach carries low risk because I already own the underlying asset. If a contract expires in the money and gets exercised, I either find a good opportunity to repurchase the shares or utilize the naked put strategy.
Using Credit Spreads and Debit Spreads to Trade Around a Core Position
In addition to covered contracts, credit spreads and debit spreads are effective strategies to trade around a core position, enhancing returns and managing risk. Both strategies involve buying and selling options simultaneously but differ in their risk profiles and potential rewards.
Credit Spreads
A credit spread involves selling an option and buying another option with the same expiration but a different strike price, resulting in a net credit. This strategy allows you to collect premiums upfront, providing income that can be reinvested into your core position. There are two main types of credit spreads:
Bull Put Spread: This strategy is used when you anticipate the underlying stock will remain above a certain price. For example, if WM is trading at $150, you could sell a put option with a $145 strike price and buy a put option with a $140 strike price. The premium collected from the sold put exceeds the cost of the bought put, resulting in a net credit. If WM stays above $145, both options expire worthless, and you keep the premium.
Bear Call Spread: This strategy is used when you expect the stock to stay below a certain level. For instance, you could sell a call option with a $160 strike price and buy a call option with a $165 strike price. The premium from the sold call is higher than the cost of the bought call, giving you a net credit. If WM remains below $160, both options expire worthless, and you retain the premium.
Credit spreads limit your risk to the difference between the strike prices minus the net credit received, making them a safer alternative to naked options while still generating income.
Debit Spreads
A debit spread involves buying an option and selling another option with the same expiration but a different strike price, resulting in a net debit. This strategy requires an initial investment but can provide significant returns if the stock moves in the desired direction. There are two primary types of debit spreads:
Bull Call Spread: This strategy is used when you believe the underlying stock will rise. For example, you could buy a call option with a $150 strike price and sell a call option with a $160 strike price. The premium paid for the lower strike call is higher than the premium received from selling the higher strike call, resulting in a net debit. If WM rises above $160, the spread reaches its maximum value, and you profit from the difference minus the initial cost.
Bear Put Spread: This strategy is used when you expect the stock to decline. For instance, you could buy a put option with a $160 strike price and sell a put option with a $150 strike price. The premium paid for the higher strike put is greater than the premium received from the lower strike put, resulting in a net debit. If WM falls below $150, the spread achieves its maximum value, and you profit from the difference minus the initial cost.
Debit spreads limit your risk to the initial cost of the spread, making them an attractive option for traders looking to capitalize on directional moves with a defined risk profile.
By incorporating credit spreads and debit spreads into your trading strategy, you can effectively trade around your core position. Credit spreads provide a steady income stream that can be reinvested, while debit spreads offer the potential for significant returns with limited risk. Both strategies enhance your ability to generate returns and manage risk, aligning with your long-term investment goals.
Conclusion
Trading around a core position is a powerful strategy that balances stability and opportunity. By establishing a strong core position and making informed trades around it, you can manage risk and achieve consistent growth. Remember, trading is a perpetual journey of learning and adaptation. Embrace the mindset of always being a student, and you'll continue to grow as a trader.