Welcome back to Cost-basis-reduction- Part Two! In my previous post I had talked about this concept as a core philosophy of trading, investing, or of doing any part of business
In this post, we will look at putting this philosophy into practice. We'll look at some hard numbers gathered over past 8 months or so by a fellow trader.
Let's assume that we have a bullish bias. There are a few routes or strategies we can take when deciding how we'd like to position ourselves:
Let's look at three strategies as a part of our experiment:
Strategy I: Buy stock and hold
Here, we did the simplest of strategies which is to buy a stock and wait for a change in price, also known as buying and holding. Here the investor buys a stock and at a time the investor deems appropriate, he/she sells the stock.
In this example, we bought 100 units of SPY in third week of March 2017 for $238, so the total cost on the trade was $23,800. Currently the stock is about $258.58 which is healthy 8.65% return with absolutely no sweat. Easy enough, right? But is that truly our best option?
Strategy II: Buy stock and sell monthly calls against it (Covered Call)
In this strategy, we did the covered call strategy. We bought the same $238 stock and every month we will sold 30 delta calls for the following month. We chose 30 delta as it translates to a probability of about 50% probability for being ITM one month from now.
On Mar 3rd we bought the stock at $238.25 and sold April 30 delta call at a strike price of $242 for $1.45 ($145). We bought back this same call for free on Apr 20th and sold a May $239 Call for $1.49 ($149). This cycle kept repeating every month.
With every trade, we kept collecting premium by sell calls. And by collecting premium, we kept reducing our cost basis putting us at a gain of about 8.27%.
This is slightly less than the 8.65% gain in previous strategy as there were months when SPY went up too fast causing us to buy the calls back at a loss.
Complete log of the trades is listed as below:
Strategy III: Buy long dated option and sell monthly calls against it
For this strategy, we did a diagonal spread. A diagonal or time-spread is when you buy a far month option while selling a close month option (to be further explained in future post).
In this strategy, we bought 10 ATM Dec calls at a strike price of $238 and paid $11.39 ($11,3900) for each call. Against each of these, we sold 10 calls at 30 delta in the monthly options about 30 days away. Towards the end of the expiration, we bought back the monthly calls and sold the 30 delta call the following month. Like the covered call, the diagonal spread is a similarly cyclical process.
This strategy is also called a poor man's covered call as you might have noticed that we bought a far month call option paying $11,3900 instead of buying the SPY stock itself for $23,800. At about half the price, we are control 10 times more units. Though this strategy comes with more leverage, it also comes with more risk. Nevertheless, the return on this strategy was 89.20% !!
After about 8 months, we can look at how the different strategies fared in the chart below:
The baseline is the white dotted line which is the price that we bought the SPY stock in March at $238.
In the Strategy II and III, we have reduced the cost basis of our stock considerably while in Strategy I we didn't do anything and we are still holding on to the stock hoping that it'll keep going up perpetually. How would Strategy I fare if there's a 2% or 5% pull back? There is no cushion room in Strategy I to recover from this kind of pullback. However with Strategy II and III, both can withstand a mild to modest correction in stock price.
The entire goal of the Strategy II or III is to reduce the cost basis down to zero so that in few years you own the stock free and clear.
Note on commissions: for sake of simplicity, we are ignoring the price of transactions. But I'll note it that it costs about $6 to buy 100 units of SPY. Each option transaction is $1 per trade without any overheads. So you'll see that the cost of entry or exit is pretty negligible for our purposes here.
Ninteen year-old trader, future connoisseur of options.
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