In Part 1 of this series we discussed how to trade around a core position, including identifying optimal stock candidates. Here we’ll take a closer look at the methodology and mechanics of making those satellite trades.
Once you have your core position established, it's time to decide what criteria you’ll use to potentially trade around it. There is no right or wrong way to approach this, but most of the trade triggers you’ll use will be based on time or events.
All in How You Frame It
When trading around a core position, you’re essentially trading two different time frames simultaneously: the long-term and the short-term. And that means one of the best indicators is a moving average.
There are three standard moving averages commonly used to represent short-, intermediate-, and long-term time frames—the 20-day moving average, 50-day moving average, and the 200-day moving average. So, for example, you might trade around a core position by playing the 20-day moving average against the 200-day moving average.
Let’s say you buy more of a stock when it breaks below its 20-day moving average but stays above its 200-day moving average. You’re trying to take advantage of a stock that exhibits short-term weakness—represented by the drop under the shorter of the two moving averages—while still continuing in a longer-term uptrend, supported by the fact that it’s still above the longer moving average.
The Main Event?
Events—earnings announcements, new product launches, boardroom reshuffles, and so on—are another trigger that you can use to initiate satellite trades around your core position, although they’re less objective than indicators or studies.
Events tend to create short-term distortions in a stock's price that can potentially be exploited to your benefit. For instance, suppose your stock were to gap higher, getting ahead of itself after a surprise upside earnings announcement. You could take advantage of this temporary price spike by selling part of your core position with the idea of buying those shares back when the price settles down.
The opposite holds true for events that temporarily exaggerate price to the downside. Those can be opportunities to pick up a stock at a cheaper price point. You can then potentially unload it if the price recovers.
It's important to note that when a stock makes an extreme move because of an unexpected event, you shouldn’t necessarily expect the price to retrace completely. So it might be a case of selling part of your core position when a stock jumps from $100 to $110, for example, with an eye to buying it back around $105.
Don’t Ignore Risk
Just because you have a long-term outlook on your core position doesn't mean that you can ignore risk management on your satellite trades. In fact, satellite trades that go too far against you can be a warning sign that your core position should be reevaluated.
If the short-term price action damages the long-term outlook for your stock, you should consider closing out your entire position. Otherwise your short- and long-term positions (and trades) are no longer working together, but against each other.
Editor’s note: This is the second in a two-part series on trading around a core position. Read the first.
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