"Cost basis reduction" (CBR) is a simple but ignored concept when it comes to investing or trading. Consider a case of buying or selling anything in the non-trading world. Let's suppose you were trading baseball cards with your buddies; your prime objective would be to buy the product at the lowest possible cost and then sell it at the highest possible price (that the market would support) and thereby profit on the transaction. If you can't buy the product at a low cost you'd look for an avenue to get the product at the cost lower than what it is being currently offered to you at. If you were a deli store owner and your supplier is selling you vegetables or meat at $1 per lb, you'd always be on a look out to get the same elsewhere at a rate better than $1 per lb as that'll increase your profit margins (assuming your operating costs and selling price is not going to change). In your personal life, you are always looking for that deal to buy that latest gadget for a lowest price possible. If the store has lured you to their location to purchase it a specific discount, you'd always look up the price online to see if you can get a better deal there.
Now in terms of investing, if you had purchased a secondary home or property as an investment, you are most likely to rent it out. It's highly unlikely that you would invest a big chunk of your savings into a secondary home/property and hope that in, say, ten years the property would have appreciated and you'd have sold it for a profit. Imagine two property owners: Bob and Jane. Bob and Jane both invested some savings they had in a secondary home as an investment vehicle hoping that it would appreciate over the next ten years and they'd have some profit after selling it. They bought this property for $100K in late 2007 just before the financial crash. Given the market situation after the crash and the slow recovery, in 2017 the property is still worth only $50k or about half of what they each paid for their property. But, what if Jane had rented the property for $500 per month while Bob did not. Jane had collected about $60,000 in rent ($500/month for 120 months) and technically reduced her cost basis on the property from $100K to $40K. While Bob's still holding on to the property for $100K and hoping that the market will turn around. Of course, Jane's also hoping that the market will turn around so she too can sell the house for profit. But the difference is that Jane's cost basis on the house is just $40K and she'll already sitting on a $10K profit. Having this will help her sleep a lot better at night and will give her the freedom to sell the property a lot earlier than Bob who's currently hoping for a 200% turn in the market for him to break even and sell without a loss (not to mention a lost decade where his money did not appreciate while the cost of living and inflation did).
Now apply this principle to trading. People generally buy a stock and follow the 'buy and hold' approach which means that they'll buy and hold it as long as it takes to make a profit. You may have heard of tales as to how the best performing portfolios are of those who haven't touched their portfolio due to passive investing. Buying something and just hoping for years in hopes that it'll go up is not a likely-to-be profitable strategy, especially when there are options (pardon the pun) to reduce my cost basis so that I can make a profit a lot sooner. Poor Bob might be waiting years for his investment to allow him to rake in some money, while Jane is stress free.
Here's one of my favorite visualization of cost basis reduction courtesy of TastyTrade.com (segment: "Strategies in IRA" dated Jun 21st 2016)
Often two (or more) items might have a mutual relationship with each other. No we aren't discussing personal, professional, romantic or platonic relationships but rather one of mathematical and statistical nature which can be employed when trading or investing.
Take the clothing industry, for example. We often see that the behavior of seasonal clothing is dependent upon the season we approach. As the frost settles on our lawns, we see an increase in sales of winter coats and cozy mittens. As it becomes colder, demand for winter wear skyrockets, yet as sunny days approach, we begin to find ourselves more intrigued by the latest trends of spring season. If we were to plot these trends in dropping temperature against sales of winterwear, we would see an indirect relationship; as temperatures dip, sales increase but as temperatures rise, sales decrease. If we were to plot the trends of dropping temperatures against the sales of summerwear, conversely, we would see a direct relationship; as temperatures dip, sales dip and as temperatures rise, sales rise.
How can we describe this?
Direct Relationship -> Positive Correlation --> The two variables move in unison
Indirect Relationship -> Negative Correlation --> The two variables move in opposite directions
Can this correlation be measured mathematically? Absolutely! If we have the data points for the pair at different points in time, we can use the statistical formula:
The above formula is for the Pearson Coefficient Formula. We will discuss the formula further in depth in later posts, but for now it's important to understand the importance of formula yields. The formula can yield a number between 1 and -1. For the results above 0.3 through 1, there exists a positive correlation between the two items tested; that is, the two items move in unison or rise/fall together. The higher the number, the more positive and better the correlation. For results below -0.3 through -1, there is a negative correlation between the two items tested; that is as one item rises, the other falls or vice versa. The lower the number, the more negative the correlation. Results between -.3 and .3 generally do not matter to us traders as there is often not a strong enough statistical relationship between the items in that range.
If you use tools like Microsoft Excel, it is pretty easy to calculate correlation. In the image, correlations are calculated between the four major index ETFs:
So, how does this apply to trading, again? If we know that there is a high positive correlation between two underlyings and if we see a divergence in this correlation, we can assume that the historically positive correlation between the two has broken and we can place a trade that reverts back to the mean. This we will cover in detail when discussing "pair's trading".
While correlation is a great tool to place trades, not all correlations are tradable as numbers alone tell the whole story. Here's a link to site that lists some funny or spurious. Who knew that per capita consumption of chicken correlates pretty highly with total US crude oil imports!
Eighteen-year old trader, future connoisseur of options.
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