Cost basis reduction

The original value of an asset is called as its cost basis. The act of reducing the amount paid for the asset is called as Cost basis reduction. The stock prices are assumed to move randomly when no new information is added to the market. The assumption is that stock prices will move in a log normal fashion around the current market price. If this holds, then the stock price would have a lower probability of touching the outer extremes. The is can be used to our advantage to reduce the cost basis.

The cost basis can be reduced using mainly three techniques - Naked put, Covered call and covered call combined with a purchase of a further out of the money call, or as I like to call it, Covered call spread. All three have different advantages and risks. It is important to understand the scenario to choose which techniques to choose from.

Naked put
This involves a sale of an out of the money put option, with the hope that the stock will not fall below the option strike. The premium collected goes towards the cost basis reduction.

• When to buy - We have enough cash to buy 1 or more lot of the underlying. But we would prefer to reduce our cost basis.
• Choosing the underlying - As we expect the stock to not move below a price, we should choose an underlying which has formed a support and does not expect bad news in the future
• Choosing the put - We should choose a strike below the support level, or one standard deviation below the current market price.
• Calculating return - Return is calculated as premium collected upon cash kept aside to buy the stock.
• Booking profit - The position is held till expiry.
• Managing loss - If at all the stock price touches the support level, it can either mean the stock is cheap in which case, we buy back the put at a loss and buy the stock. A further out of the money put can also be sold to collect more premium and cover our losses. Or it can mean the stock is not worth buying. In which case an out of the money call can be sold.

Covered call

This involves a purchase of the underlying and sale of an out of the money call option, with the hope that the stock will not rise above the option strike. The idea is that we are capping our profits to reduce our cost basis. The premium collected goes towards the cost basis reduction.

• When to buy - We either already hold the stock or would like to buy the stock as we are bullish on the stock, but don't know when the stock would rise. Also we have enough cash to buy 1 or more lot of the underlying and enough to hold for margin. 
• Choosing the underlying - As we expect the stock to not move above a price, we should choose an underlying which has good fundamentals and are quite sure of stock not falling down.
• Choosing the put - We should choose a strike above the resistance level, or one standard deviation above the current market price.
• Calculating return - Return is calculated as premium collected upon cash invested in the underlying and the margin kept aside.
• Booking profit - The position is held till expiry.
• Managing loss - If at all the stock price touches the option strike, it means the stock is moving well. Best idea is to book a loss on the call option and sell an out of the money put to cover the loss. Another way to deal with it is to convert the position to Covered call spread and finance it with a out of the money put.

Covered call spread

This involves a purchase of the underlying and sale of an out of the money bearish call spread, with the hope that the stock will not rise above the option strike of the sold call. The idea is that we are capping our profits to reduce our cost basis and protecting ourselves against any large upward movement. Although the safest of the three, it also gives the least return.

• When to buy - We either already hold the stock or would like to buy the stock as we are bullish on the stock, but don't know when the stock would rise. Also we have enough cash to buy 1 or more lot of the underlying and enough to hold for margin. 
• Choosing the underlying - As we expect the stock to not move above a price, we should choose an underlying which has good fundamentals and are quite sure of stock not falling down.
• Choosing the put - We should choose a strike above the resistance level, or one standard deviation above the current market price.
• Calculating return - Return is calculated as premium collected upon cash invested in the underlying and the margin kept aside.
• Booking profit - The position is held till expiry.
• Managing loss - If at all the stock price touches the option strike, it means the stock is moving well. Best idea is to sell an out of the money put to further extend the profit.