Averaging Your Cost

You increase your profit potential with call writing using a strategy known as average up. When the price of stock has risen since your purchase date, this strategy allows you to sell in-the-money calls when the average basis in that stock is always lower than the average price you paid.

If you buy 100 shares and the market value increases, buying another 100 shares reduces your overall cost so that your basis is lower than current market value. The effect of averaging up is summarized by examples in Table .

How does averaging up help you as a call writer? When you write calls on several-hundred-share lots of stock, you are concerned about the possibility of falling stock prices.

While price decline means you will profit from writing calls, it also means your stock loses value. Covered call writing provides downside protection, but that is limited; if price decline extends beyond the discounted basis of stock, then you have a problem. The more shares you own of a single stock, the higher this risk. For example, if you are thinking about buying 600 shares of stock, you can take two approaches. First, you can buy 600 shares at today's price; second, you can buy 100 shares and wait to see how market values change, buying additional lots in the future. This means you will pay higher transaction costs, but it could also protect your stock's overall market value. By averaging your investment basis, you spread your risk.


Averaging Up

DateShares PurchasedPrice per ShareAverage Price
January 10100@dollar;26@dollar;26
February 101002827
March 101003028
April 101003028.50
May 101003129
June 101003229.50

Example

A Law of Averages: You buy 100 shares on the 10th of each month, beginning in January. The price of the stock changes over six months so that by June 10, your average basis is $29.50.

This example, as illustrated in Table above, allows you to reduce stock investment risk. The average price is always lower than current market value as long as the stock's price continues moving in an upward trend. Buying 600 shares at the beginning would have produced greater profits. But how do you know in advance that the stock's market value will rise?

Averaging up is a smart alternative to placing all of your capital at risk in one move. The benefits to this approach are shown in Figure below.

[caption id="attachment_12511" align="aligncenter" width="360"]Example of averaging up. Example of averaging up.[/caption]

By acquiring 600 shares over time, you can also write six calls. Because your average basis at the end of the period is $29.50 and current market value is $32 per share, you can sell calls and with a striking price of 30 win in two ways:
  1. When the average price of stock is lower than striking price of the call, you will gain a profit in the event of exercise.
  2. When the call is in the money, movement in the stock's price is matched by movement in the call's intrinsic value.

What happens, though, if the stock's market value falls? You also reduce your risks in writing calls if you average down over time. An example of this strategy is summarized in Table below.

Averaging Down

DateShares PurchasedPrice per ShareAverage Price
July 10100$32$32
August 101003131.50
September 101003031
October 101003030.75
November 101002730
December 101002429

When a stock's market value falls, selling calls may no longer be profitable; you may need to wait for the stock's price to rebound. This does not mean that selling calls on currently owned stock is a bad idea; a decline would affect portfolio value whether you wrote calls or not. In fact, if you do write calls, you discount the basis of stock, mitigating the effect of a decline in market price of stock. A decline that is only temporary has to be waited out because it makes no sense to set up a losing situation. You should never sell covered calls if exercise would produce an overall loss.

Smart Investor Tip

When the stock's market value declines, selling covered calls is less likely to produce profits. Never write calls when exercise will produce a net loss.

In this situation, selling calls out of the money may also fail to produce the premium level needed to justify the strategy. When stock has lost value, wait for its price to recover; meanwhile, if you continue to believe the stock is a worthwhile long-term hold, acquire more shares through averaging down.

Example

Reducing the Basis: You buy 100 shares of stock each month, beginning on July 10, when market value is $32 per share. By December, after periodic price movement, the current market value has fallen to $24 per share. Average cost per share is $29.

Your average cost is always higher than current market value in this illustration using the average down technique, but not as high as it would have been if you had bought 600 shares in the beginning. The dramatic difference made through averaging down is summarized in Figure below.

[caption id="attachment_12512" align="aligncenter" width="354"]Example of averaging down. Example of averaging down.[/caption]

When you own 600 shares, you can write up to six covered calls. In the preceding example, average basis is $29 per share. By writing calls with striking price of 30, you gain one point of capital gain on the total of 600 shares in the event of exercise. This demonstrates how averaging down can be beneficial to call writers in the event that the stock's market value falls.

Averaging up and down are important tools that help you to mitigate the effects of quickly changing stock prices. In a fast-moving market, price changes represent a problem to the call writer, since locked-in positions cannot be sold without exposing yourself to greater risks in the short call position. Both techniques are forms of dollar cost averaging. Regardless of price movement, averaging protects capital. A variation of dollar cost averaging is the investment of a fixed dollar amount over time, regardless of per-share value. This is a popular method for buying mutual fund shares. However, in the stock market, direct purchase of stock makes more sense when buying in round lot increments.

By averaging out the cost of stock, you reduce exposure to loss in paper value of the entire investment. For the purpose of combining stock and option strategies, owning several hundred shares is a significant advantage over owning only 100 shares. Transaction costs involving multiple option contracts are reduced; in addition, owning more shares enables you to use many more strategies involving options. For example, if you begin by selling one call, you can avoid exercise by rolling up and increasing the number of calls sold. This provides you with more premium income as well as avoiding exercise, even when the stock's market value is rising. By increasing the number of options sold with each subsequent roll-up, you can increase profits over time. The technique is difficult, if not impossible, when you own only 100 shares of stock.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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