Reducing Your Cost Basis With Options
Here’s another way think about it:
While most investors only wait around for the big move up, why not sell option premium to work the cost basis (the amount of money you paid to buy the stock) down?
If this strategy is executed successfully, the investor will have enough “padding” on the position to allow for an unforeseen drop in the price, due to the fact that the premium (or money) they have gained from consistently selling options against the stock position has added small gains to it over time.
Here’s an example:
On March 20th, $WYNN received an upgrade and rose 6%.
Since the stock made a substantial move to the upside, the Call option premiums also increased.
After this particular upgrade, the 95 Calls in April rose in price 230%, more than they were before the analyst upgrade. This makes for a decent opportunity to sell premium.
The strategy in action:
Much like chess, trading is about thinking several moves ahead. We know that if an investor sold these Calls against a starter position in the stock, that they will be protected $3.00 below the price they initially paid for the stock. In other words, they would be protected down to $91.47 ($94.47 minus $3.00 in option premium collected).
Now what happens if the stock falls below an uncomfortable level?
One method would be to buy back the 95 Calls and sell another Call a bit lower, or farther out in time, or both. This aligns with the theme of always working the cost basis lower.
What would be the plan if the stock continues even higher?
The investor could let the stock get called away, or possibly “roll” the Call up and out in time, collecting an equal amount of premium by selling another Call which is equal in price.
Keep in mind, these are just two of the ways an investor could adjust this position. There are many other advanced strategies such as the following:
ON AN UP MOVE: The Calls could be rolled up to higher strike prices and the rest of the premium needed could be financed by selling puts.
ON A DOWN MOVE: Due to the fact that in this example the investor initiated the trade with a starter position, they could acquire more stock at a lower price and sell more Calls, reducing the cost basis even more.
MAKE IT A SET-RISK POSITION: The position could be changed entirely into a Bull Call Spread and have a limited downside. This would be the ideal adjustment if an investor was not able to actively monitor the position on a routine basis.
Here is why these strategies work well:
In trading, rarely should an investor be at the mercy of only one outcome. As more experienced traders know, a trader should remain flexible and have a solid plan before they enter a position and be thoroughly prepared to admit they are wrong and adjust according to their plan.
This is a formula for long-term growth. It requires patience, practice and planning to be successful. It can also be abused by over-adjusting too. So investors need to be mindful of this if they choose to implement this strategy.
By Derek Devore