Your Portfolio Has a Job to Do. Put It to Work: Core Positions

When you fall in love with the markets and begin to stare endlessly at a trading screen, you’re exercising your brain more than your muscles. And maybe you begin to notice some, well, “accumulations” and decide to hit the gym. What’s the first thing your new trainer says? You’ve gotta work your core! You know, abs, back, middle. Without a strong core, the rest of you can’t do much. 

In market-speak, an investor might have a core portfolio composed of stocks that compel a long-term outlook. Investors passively hold on, enjoying the good times and riding out the bad. The research is done, and decisions are made. Investors hang in there, and believe returns will come eventually. Hopefully.

Consider the Possibilities

For a trader, core positions can also do other things. Much like your body’s core provides support for strong arms and legs, a trader’s core position might be a single longer-term position based on a bullish or bearish bias that can support other positions and shape return and risk. In effect, a trader uses the core position as a tool to store capital, and trades around it. 

What does that mean? The core position is a longer-term speculation that hopefully makes money in its own right, but it also supports other, short-term positions that may generate cash flow and create returns on the overall portfolio. Basically, a trader tries to squeeze returns out of a core position by finding potential opportunities in varying market conditions. 

Trading around core positions adds work, and often adds commissions. But even if you don’t go all the way and treat your core positions like a trader might, there are things you can do that don’t deviate too far from a passive approach. 

The Benefits of Staying Active

For example, some traders may view a stock or future core position that lacks an option “overlay” as sitting idle. And they may look for ways to increase short-term returns on it. 

Let’s consider a bullish speculation in crude oil. A trader may put on crude oil futures in expectation of rising prices. The futures expire, so the trader may roll them from one month to the next to maintain this long-term, core bullish strategy. Does the trader know oil is going higher? Of course not, which is why the core position is speculative. But the trader also knows that adding certain option overlays, like a short call on a crude oil future, brings no additional margin requirement or risk to the core portfolio. In fact, the short call can add positive theta, which benefits the trader’s daily profit/loss. The short call also reduces the breakeven point of the long future. In exchange, the trader gives up some of the core position’s upside potential. 

In this scenario, the trader is often more confident in the option overlay than on the speculative bullish oil trade. She knows the theta of the short call is positive, and when the future’s breakeven price is lower, the risk is lower, too. 

Another trader might have a bearish core position and sell puts against it, with the same rationale as selling calls against a long future. The option overlays can get complex in response to different market scenarios, like hedging across markets and balancing notional values. 

Investing Like a Trader

In some cases, an investor can use a trader’s tricks. Of course, you know to sell calls against a long stock core portfolio. Say you’re long shares of XYZ, ABCD, and GVRC, and you choose to sell calls in all three against their respective shares. Simple. But what if your core portfolio isn’t so tidy? What if it has shares in a company that doesn’t have any options traded on it? Or what if your core portfolio contains a bunch of odd lots—150 shares here, 75 shares there? It takes 100 shares to cover the risk of most stock options. This is when thinking like a trader can help.

In thinkMoney 33, we discussed how to potentially generate income on a long stock position with covered calls. This is often handy for a single stock position. Let’s extend that discussion to (1) a stock position that doesn’t have options, and (2) a position in a stock basket that would require too many transactions or not qualify for a covered call.

A long stock position in a small company with no calls to sell.
Maybe you have shares from an employee-stock program or inheritance. Or maybe it’s a company you really like, but the stock doesn’t have options, and you don’t want to sell the stock and buy another. Let’s call your stock XYZ. How can you sell calls against it?

To solve the problem, turn to the tools on the thinkorswim^® platform from TD Ameritrade. Consider selling call vertical spreads in a stock that has options and a high correlation to XYZ. (Correlation is the numerical value that describes how closely XYZ moves with another stock or index.)

First, look at stocks in the same industry sector. Is XYZ a biotech company? An energy company? High tech? On the Scan tab, click on “Scan In” in the upper left-hand corner, and from the dropdown menu, click on “By Industry” at the bottom (Figure 1A). Here you can narrow the stocks into a specific industry. Next, click on “Intersect With” and select “Category,” then “All Optionable” (Figure 1B). Then click on Scan.

This loads up a list of optionable stocks in the same industry as XYZ. Next, find one that has a high correlation to your stock. Go to the Charts page, click on Studies in the upper right-hand corner, select “Add Study,” click on “All Studies,” then “C-D” to find “Correlation” (Figure 2). This will display the correlation between XYZ and the SPX (by default) on the chart.

You can then edit the Correlation study, replace SPX with XYZ, and enter the symbol of an industry stock to see how it correlates with your stock. The closer the correlation is to 1.00 (max correlation value), the closer to perfect positive correlation. Keep in mind that correlations can change over time, and there’s no guarantee the industry stock will move up and down at the same time as XYZ.

Now, look at the options on that industry stock, and consider an out-of-the-money (OTM) call vertical to short. Why a call vertical? Selling a naked call in a stock you don’t own has unlimited risk if that stock rallies and XYZ—the stock you own—doesn’t. Because a call vertical has defined risk, even if the correlation breaks down, and the industry stock rallies while XYZ drops, the loss on the short call vertical won’t exceed the maximum amount.

Finally, you need to figure out how many call verticals to sell in the industry stock. First determine the value of your XYZ shares. Then divide that value by the price of the industry stock to see roughly how many shares your position in XYZ represents. For example, if you have 1,000 shares of XYZ trading at $25, the value of your XYZ position is $25,000. If the industry stock is trading at $75, then $25,000/$75 = 333. If the two are perfectly correlated, theoretically, your XYZ position has the same value as 333 shares of the industry stock. So, you may want to consider selling three call verticals in the industry stock. 

Selling call verticals in a different stock from your core is a way to add theta to your portfolio. It adds a certain amount of defined upside risk, as well as commissions, but that positive theta is one way to potentially add a little extra return to an otherwise “lazy” core stock.

Smaller odd-lot positions in stocks where selling calls is not possible.
Over time, perhaps by making smaller investments in individual stocks to diversify a portfolio, you may have acquired odd lots in 20, 30, or more stocks. An odd lot is a number of shares that isn’t evenly divisible by 100. For example, 225 and 560 are odd lots. A single option represents 100 shares of stock. So, if you have 225 shares, you can’t sell 2.25 calls. You could sell two calls against 225 shares, but that would mean 25 shares, or 11%, of that position isn’t working as hard for you as you may want. Besides, you may not want to look for calls to sell in 20 or 30 stocks.

You can apply the same process just discussed to selling a call vertical in an index that could be a benchmark for your portfolio. Let’s say your core portfolio consists of 30 small-cap stocks. The NASDAQ 100 index could be a benchmark for your portfolio. The Mini NASDAQ-100 Index (MNX) is an index on the NASDAQ that also has options. The MNX has a contract multiplier of 100. So, if MNX is trading at $550, it has a notional value of $55,000. If your core small-cap portfolio is worth $100,000, its value is nearly twice that of the MNX. So, you might consider selling two OTM call verticals in MNX options.

Again, the MNX call vertical offers your core small-cap portfolio defined risk and positive theta. It also offers the potential to increase returns over time in exchange for upside risk if MNX moves up more than your core portfolio and commissions.

Work That Core

Selling call verticals against a core portfolio is just one strategy to consider, and it may or may not fit your objectives. But the larger goal is to review long-term positions you may be sitting on as assets that could be working even harder for you. You’ve worked diligently to construct a sensible portfolio. Make sure it’s doing all it can.