Tales of a Technician: Portfolio Structure for Active Trading

In continuing with our exploration of portfolio structure, today we’re addressing how an active trader might go about deciding how to allocate his portfolio. If you’re serious about learning this, then I highly recommend reading my previous piece on portfolio context to understand the different investment approaches. Today we’re focusing on the Performance Juicing, Busy Bee. You’ll recall this method involved the following three steps:

Step One: Decide what type of active trading you want to adopt. Is it stock trading, option selling, futures betting, or Forex? Is it day, swing, or position trading? Or is it a combination of all of them?

Step Two: Build a detailed plan surrounding your strategy complete with position sizing, risk mitigation and profit capturing.

Step Three: Deploy mercilessly when appropriate and reap the rewards. Rinse and repeat.

Given the breadth of strategies involved in the world of active trading, it is impossible to provide a cookie-cutter method for determining the optimal way to invest. Nevertheless, I have some ideas that you should find helpful. Since option selling strategies is my bailiwick I’ll be focusing on a portfolio that uses naked puts, credit spreads, condors, and the like for swing and position trading.

Risk Management is Paramount

No matter what your active trading style is, you have to abide by a sound set of risk rules, or you’ll inevitably blow up or quit. Determining how many trades to do on a regular basis in your active trading account depends in large part on how much risk you’re taking per trade. For example, someone risking half of one percent in each trade may be able to have twenty positions going simultaneously. But for someone risking three percent per trade, it would be entirely inappropriate. So, the less you risk per position, the more positions you can have open simultaneously.

The next concept is directly correlated with the first. You have to keep tabs on your overall portfolio exposure. I’ve seen students slowly accumulate positions in low volatility, bullish trends unaware of the aggregate risk. Then, during when the market dropped they suddenly realized with horror how much leverage they truly had. Seeing 20% of your portfolio melt away during a 5% market drop is just the worst.

In conclusion, no matter what your active trading tactic — whether you’re day trading stock, or position trading option premium plays — you must keep the risk per trade to a minimum and keep the aggregate portfolio risk in check. I encourage you to create a monthly loss limit defining the max amount you’re willing to sacrifice in a bad month.

Core versus Discretionary

You have to have a method to your madness when active trading. Otherwise, your portfolio will turn into a potpourri of positions with little rhyme or reason. It’s also imperative that you’ve proven your ability to make money with whichever strategies you employ. I suggest deciding what your core systems are going to be versus discretionary. For example, suppose you have three core trading systems that you are confident will make money over time. Further, you want to deploy them every single month with the majority of your portfolio. The first is the Condors for Cash Flow system on the Russell 2000 Index. The second is a naked put system on a few ETFs (like EEM and XOP). And the third is a covered call system on the overall stock market via IWM.

The beauty of having a trio of core systems is you already have the bulk of your capital spoken for every month. You no longer have to wake up on Monday and figure out which stocks to trade and when to enter. At least not with this part of your capital.

Let’s say we allocate 75% to core systems.

For the other 25%, we’ll allow discretionary trades. These could be swing trades deployed from selections in the weekend Stock or Options report. They could be low risk, high reward setups you discover in your watchlist. Whatever the case, we’ll consider these your tactical trades for opportunities that arise on a regular basis. Having one-quarter of your portfolio available gives you the freedom of swinging at the occasional fat pitch that comes your way instead of having everything tied up in core positions.

Obviously, you can vary the percentages to fit your needs. I suggest allocating the lion’s share to the systems and strategies you’ve proven work best for you. The more speculative or discretionary the trade, the less capital you should commit to it.

It’s worth noting some traders may favor splitting their portfolio pie into slices of Cash Flow, Growth, and Speculation. My preference for the “core vs. discretionary” is to differentiate between systems deployed on a monthly basis versus one-off trades that I have to search for on a daily basis. The first approach requires less skill and timing prowess, relying instead of the inherent merits of a strategy (like condors and covered calls). The second approach requires more skill making it a more challenging method to use for churning out consistent profits.

Become a Journaling Champion

The best way to discover which systems you should allocate the most capital to is to record your results. It’s a crime that so few traders understand why they’re making or losing money. If you don’t identify what’s working and what’s not then you won’t be able to make the necessary adjustments to improve. Personally, I track each system separately, so I know their respective performances. That means I have a journal (a tab, really) dedicated to the Condors for Cash Flow system. I have another for core naked put and covered call systems. Finally, I have a one for discretionary trades to track if I’ve lost my touch or if jumping around like a jackrabbit still adds value to my overall approach.

If you want to compare today’s allocation ideas to what a covered call portfolio might look like, then read this too.

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