Lowering Cost Basis with Options

In this post I wish to talk about lowering the cost basis of a position. I will also show a trade that didn’t go so well, but still showed a profit because I managed to lower my cost basis. It is important to note that this post is not about the tax definition of cost basis, but rather the practical implications of lowering cost basis over the long-term.

Lowering Cost Basis

There are many ways to lower cost basis. For example:

  • Use market correction to increase position – For example : buying stock XYZ @ $100 then when it goes to $90 double your position. If the stock goes back to 100$ you own twice the amount with a cost basis of $95.
  • Dividends – If you bought stock XYZ for $100 and then it distributes a dividend of $5. We can say that the new cost basis is $95.
  • Selling options – If you bought stock XYZ for $100 and then sold OTM call for 5$ and it expires worthless. The new cost basis is $95.

These are just examples, of possible outcomes. They are not guaranteed. But while we can’t control stock volatility, we can buy stocks that distribute dividends and sell options in order to generate cashflow that will lower the cost basis.

Lowering cost basis with options – An example

It is very hard to see and “feel” the effect of the cashflow we expect to generate over a period of time in the future. For this I wish to show an example and hopefully will make the mechanism more visible. I wish to use an example that is not perfect, to show that even if you make mistakes, the cashflow is forgiving and helps you profit.

BX – Blackstone Group

Blackstone is a publicly owned investment manager that manages money, etfs, funds and provides financial advice to its clients. It’s a huge company with market cap >40B$.

I started my position at 18-July 2014, when the stock appeared on my dividend capture screen. Later, I decided that I don’t want to sell the stock so I rolled the call out of the money to avoid being assigned. Soon after the stock crushed more than 25%. These are the trades I did on BX so far:

Lowering Cost Basis with options - BX Example
Lowering Cost Basis with options – BX Example
  1. Entered the position with ITM covered call for a week (tried to capture the dividend a week later)
  2. A day before Ex-dividend I rolled the call out. Luckily, I kept the same cost basis, but lost when considering commissions.
  3. Soon after the dividend the stock plummeted. I started selling OTM calls. You can see that from starting cost basis of 35.3 in July, with dividends and selling calls I managed to decrease my cost basis to $31.51 in Jan 2015 – a 11% decrease in 6 months.
  4. As the stock rose in Feb-Mar I started to roll the call out. I had to buy them at a loss and thus increased my cost basis.
  5. Even though, even my trades were not perfect, you can see that selling covered calls managed to increase my profits compared with plain-vanilla stock position (and will the same risk).

For visual aid, This is the stock chart:

BX - Stock Chart
BX – Stock Chart

Key Takeaways

  • Even though my trades were not perfect, I managed to increase my profits: 16% instead of 9% for a plain stock position.
  • Often I see traders that are wary that covered calls limit the upside. You can see that it’s true, but over the long run the benefits outweigh the disadvantages.
  • Dividends and calls create strong cashflow from a stock position. You can profit even if the stock is range-bound.
  • Even if a trade went against you, if you believe in the company, slowly decrease your cost basis and when the stock rises you will increase your profits.
  • It is important to remember that not all stocks are suitable for this strategy. I wouldn’t use it when the stock is known to gap or the story of the company is all or nothing (like biotech stocks). There are other strategies that will better suit these stocks.

 

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