Cost Basis
Reduction Implementation through options
This
article is trying to make it a simple explanation of selling premium to help
increase profits and reduce a trader’s cost basis on a stock/ETF. Due to the numerous
questions, this hopefully clears up some of them.
The benefit
of using options is the ability to improve your cost basis when you wish to get
involved into a particular share or ETF. What this means is the following;
When
looking for investment opportunities the key to continually understand is that you
can and probably are, wrong. Even though we do all this research and only go
long at lows (buying at the bottom) or
selling when there has been a strong a rally (selling at the top) there are still
a lot of times an investor is too quick with the trigger in getting into a
stock or getting out.
Selling
options gives the investor more opportunities to be right. And isn't that what
we are trying to achieve. To be right more times than we are wrong. The trick
is to be right more often but then also to ensure being right leads to more
profit. I have a problem with a lot of people noting about statistical
probabilities of a short option of being right, my main focus is to structure
things to create profitable environment, not just selling premium to be right
more times than wrong. As a trader/investor I would recommend you try to
determine this to ensure you are happy with what you are trying to achieve.
Let’s go
through an example; we can go over to the ETF RSX as a live example; RSX has
been slammed in price mainly due to the ETF has substantial lean toward Energy
stocks, and it has followed the oil sector over the edge. But looking at RSX
chart a chartist can see it is forming a bottom of sorts.
Looking at
this chart a chartist can assume that there is relative support at about $14.
Can it go lower? Yes sure who knows right, Can it go higher? Yes sure it can,
but wouldn't it be great if even if it goes lower we still make money. Let me
put it this way, if when you buy a share outright the share can only go up or
down. Simple, you either make a profit or a loss. But with and when selling a OTM put option if the price goes up you make
money, if it goes down (but stays above your strike price) you make money, and
if it goes down below your strike price and you get exercised you start to lose
money from that point, but only below any premium you have received. It really
places the odds in the traders favor.
Let’s look
at the example in further detailing;
Current RSX
share price: $15.70
Put: Strike
price of $14 Approx. 45 days’ time is selling for about $0.50. As options work
in 100 shares this means if you sell an option you will receive $50 into your
brokerage account.
Margin required
to hold the Put options is approx.: $390
So what
does all this mean, well it means that in 45 days’ time, if the share price is anywhere
above $14 you have made $50. Based on the Margin of $390 this means you have
received a return on your capital of 12% for 45 day period. So to continue to clarify the stock has to
fall from $15.70 to $14, an 11% drop and we can still make a profit. As long as
it is above $14 we will profit from this particular section of the trade.
Now let’s
move forward to the second section of the trade. Let’s assume the
investor/trader did not “Roll Over” or close any of the option positions and
wished to get assigned. Let’s re-look at the math; if the strike price is $14
and we have received $50 in premium already, our break-even is now $13.50. This
means that at any point the stock is above $13.50 we are profiting from the
combined trade of the option and stock value.
As an
investor you must make sure this is the strategy you wish to deploy, as there
are multiple different strategies within a strategy here, and you will need to
assess your own risk if you wish to get the stock assigned or close the option
or roll over. This is on a case by case basis and this article is not telling
you to do it a certain way, but rather showing the math behind how to and where
to get multiple profit opportunities by using options.
The trader
also needs and should pay attention to Volatility as a high volatility within
the option will ensure more premium is received, and this means more
opportunities to gain more profits. Never forget Volatility.
As a Value investor using put options is a fantastic way to get involved into your stock at lower prices and continually reducing your cost basis on the stock.
All options carry risk and the risk is that the stock could continue to fall to $0. This would mean a total loss of the share price times the amount of contracts you sold short. A trader can make their own risk calculations about the probability that can happen. When trading strong fundamental stocks and ETFs the risk is as close to mitigated as possible due to the research the trader/investor has put into knowing the company and business. But note that this comes at a price and the price is that most of the times Volatility is lower. Lower volatility means lower income premium.
To mitigate portfolio risk further it is always a good practice to keep your trade size smallish in relation to your portfolio. This will ensure that if the share is exercised you have capital to maintain the position you believe in as well as to continue to implement further cost reducing strategies, if your belief in the stock has not changed.
