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.
"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)
Ninteen year-old trader, future connoisseur of options.
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