One of the most important fundamentals of our trading philosophy is cost basis reduction. So, what is cost basis reduction? Cost basis reduction is simply decreasing the cost of something we own over time. This usually means reducing our cost of a stock or a stock equivalent such as an option.
With that said, why would we want to reduce our cost basis? As an example, let’s say we bought a stock for $50. Through cost basis reduction strategies, it is possible to decrease our cost of the stock to $0 over time. If we bought the stock at $50 and we decreased our cost basis to $45 with the stock still at $50, our probability of making money has increased. This is why cost basis reduction is such an attractive strategy.
Why wouldn’t we want to reduce our cost basis? Put simply, the only real reason we wouldn’t want to reduce our cost basis is because it limits our upside potential.
What strategies can we use to reduce our cost basis? Perhaps the most common cost basis reduction strategy that most investors first become familiar with is the covered call. The covered call is comprised of 100 shares of long stock and a short call. If we buy a stock for $50 and can sell the 50 call for $5, we will effectively reduce our cost basis on the stock to $45 when that option expires. If we kept selling calls against that stock, we could continue to reduce our cost basis of owning the stock until we own the shares for free. This doesn’t mean that we can’t lose money on the position, as the stock could go to 0 before we reduce our basis that much, but it drastically increases our chances of making money when compared to just buying stock outright.
Another variation of a covered call is known as a poor man’s covered call, which is actually a long LEAP call and a short near-term call. This replicates a covered call position due to the long call replacing the 100 shares of stock. The cost basis reduction comes from the near-term options we sell against our long options.
Lastly, we look at the pros and cons of each of these strategies. For the covered call, our probability of profit and win rate increase dramatically as compared to just being long stock, but our profitability is limited compared to long stock. For the diagonal spreads, we benefit from increasing volatility since we are long an option with a further maturity. We also have a much higher return on capital in the diagonal trade, but run into liquidity issues if our strikes end up deep in-the-money.
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