If you are an investor or a trader the single most important action that you must take in your investing (or trading) is to lower the cost basis of the stock or option in which you have a position. (Of course if you are trading the short side, you want to do the opposite and raise your cost basis).
In light of the fact that most investors primarily trade the long side, that is you buy a stock or option and want it to go higher let’s focus on trading from the long side for now. Traders of every experience level should be able to get their head around trading long.
I trust that with every stock or option you have purchased then you probably couldn’t wait for it to go up so you could sell it for a profit. I know I experienced those same emotions. In fact I still experience those feelings. Instant gratification is too slow!! I could never understand why the instant after I purchased the stock it did not go up? After all, now I was in and I was ready to see the stock go on a tear.
Well first of all, when you finally understand the market you will discover that buying a stock is a 50/50 proposition. The stock can go up or down and your odds are exactly the same for it to move either way. Okay to be 100% accurate there is a slight upward bias in the stock market. Research has shown the upward bias to be about 53% but let’s call it 50/50 for the sake of this discussion.
If you buy a stock and the chance that it makes a profit for you is 50% then wouldn’t it make sense that if you lower the purchase price (cost basis) of the stock then your odds of making a profit will be materially increased? In fact, the only way to increase your probability of profit is to lower your cost basis in the underlying. And the most efficient way is to use derivative products. (i.e. options) Let me illustrate:
Microsoft is currently trading at 44.00
Buy to Open 100 shares MSFT @ 44.00/share $4,400.00
Sell to Open 1 Sep15 MSFT 45 Call @.85 (- 85.00)
Net Cost $4,315.00
By selling the call you have given the buyer of the call the right to buy your stock at $44.00 per share. By lowering your cost basis to $4,315 which is approximately 2% of the price of the stock, you have raised your probability of profit by 2%.
In other words you can sustain a decrease in the price of the stock by 2% (in this example) and still be at breakeven. Of course if the stock goes above your strike price of $45.00 you have capped your top side but you realized a profit of $185 (45.00-43.15)*100. Your $185.00 profit on a cash investment of $$4,315.00 is a 30 day return of 4.3%. Not too shabby!!
The challenge for most investors is to give up the potential upside of the stock they are purchasing. What is important for the investor to consider is that in the above case, there is only a 65% chance of the stock being called away. The odds for the call seller are definitely in his favor.
Only two things can happen in this case (and they are both good):
1) Your stock is called away and you make a 30 day return of 4.3% or
2) the stock does not close above $45 and you still own the stock and you keep the premium.
Now your cost basis is $4,315 and you sell another call in the next expiration cycle further lowering your cost basis and increasing your probability of profit.
Initially this may seem like a challenging concept to grasp, but it really is quite simple. With a little guidance and some experience you will find the process is practically automatic. Additionally, can there be a better way to hedge your portfolio than selling premium against stock you already own?
If you would like to learn more about generating an income from your portfolio, or using derivative products to hedge against the next, inevitable downturn in the financial markets give me a call at 239.272.3424………..I answer my own phone!