Please refer to Important Disclosure Information at the end of this research note.
This is a follow up to our post on using options to augment a core portfolio.
In our last post (A Fundamental Approach to Using Call Options to Enhance Returns) we showed how buying deep in-the-money call options can be a sensible way to enhance a portfolio without risking too much capital.
In this post, we discuss selling options to lower cost basis.
What is an option again?
Call (put) options are derivatives that give the buyer the right but not the obligation to buy (sell) the underlying shares by a fixed future date at an agreed upon price (the strike price).
Selling a call (put) option gives the seller the obligation to sell (buy) the underlying shares at a future date at an agreed upon price. As compensation for this obligation, the option seller is paid an upfront premium. Selling options is a lot like selling insurance with the associated risks and rewards. We will have more to say in this regard in a future post. For now, just keep in mind the concepts of right versus obligation.
Lower Cost Basis – A Twist to Buying Low and Selling High
Investing is about finding opportunities where the share price is materially different from what the underlying business is worth.
- We use business and financial analysis to figure out what a business is worth.
- We use patience and discipline to purchase shares at the right price.
Now wouldn’t it be nice if we could lower our purchase price, the cost basis, after purchasing the shares? How about getting paid to purchase the shares at the price we’re already comfortable purchasing the shares?
Method 1: Selling covered calls
By selling a call option we're agreeing to sell the shares we own at an agreed upon strike price. As compensation for this obligation we collect a premium. Just like an insurer.
Let’s illustrate with an example: If a business is worth $60 per share and the share price is $50 per share one can hope to make a 20% gain (60/50-1) by buying the shares at $50 and selling at $60.
What if we’re paid a $2 premium to agree to sell the shares we own at $60? We could lower our cost basis to $48 ($50 initial cost basis - $2 premium), enhance our projected return to 25% (60/48-1), and lower our break-even price to $48. That would be nice.
So what’s the catch? After all, there’s no such thing as a free lunch in investing.
The catch is we’re capping our upside to $60 with a maximum gain of 25%. If the shares rise above $60, our return is capped at 25% because we’re obligated to sell the shares at $60. This is not such a bad thing if our projected value for the underlying business is no greater than $60. Holding out for a higher price would be just plain greedy.
If the call option expires worthless, not only do we keep the entire $2 premium but we can now sell another call option and collect additional premium and lower our cost basis even more.
As long as we own the underlying shares, we’re not materially increasing our risk with this option strategy.
Method 2: Selling puts
An alternative approach to lowering cost basis is selling put options.
This is appropriate if you haven’t yet purchased the underlying shares or if you want to buy more shares. In our prior example, where the shares are trading at $50, instead of buying the shares outright at $50, we could sell puts at a $50 strike for a $2 premium and effectively agree to buy the shares for $48 ($50 strike price - $2 premium).
So what’s the catch?
If the shares happen to rise before our options are exercised then we risk the shares running away from us.
As long as we set aside the necessary capital to purchase the shares at the $50 purchase price we’re not taking any additional risk with this strategy compared to the outright purchase of the shares at $50.
Fear and Greed – Avoiding Behavioral Traps
At its core, investing is about avoiding behavioral traps. We have written extensively on this topic in prior posts (Don’t discount the grandma trade).
"Fear of missing out" syndrome
So you’ve done the analytical work and are ready to buy shares in your favorite company. But before you can purchase the shares they rise sharply. You believe the shares are worth a lot more and you want to own them before they run away from you.
You’re suffering from the fear of missing out. Instead of chasing the stock, consider writing a put option at a price you’re comfortable paying for the stock. That way, you collect premium, lower your cost basis, and suppress your “fear of missing out” syndrome.
"Greedy for more gains" syndrome
Say you own shares in a company you like. Your thesis has worked out perfectly and the shares are near your target price. Instead of selling your shares and locking in a profit, you’re talking yourself into believing the shares are worth a lot more.
Call this “thesis creep” or "greedy for more gains.” Consider selling a covered call option thus making the selling process mechanical. That way, you collect premium, lower your cost basis, and suppress your “greedy for more” syndrome.
Important Disclosure Information
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