Adjusted Cost Basis and Options

Adjusted Cost Basis. A nerdy sounding phrase to some, but it's music to my ears.

We know what cost basis means, as in the cost basis of one's stock holdings acquired in multiple transactions over a period of time.

Calculating cost basis is relatively simple. Suppose you purchase 100 shares of The XYZ Zipper Company once per quarter for two years. That means you've acquired 800 shares (100 shares x 8 quarters).

To calculate cost basis, you merely take the accumulated amount of money you've spent purchasing the stock and divide it by the total number of shares acquired, in this case 800. The result is the cost basis, or average share price you've paid of each of your 800 shares.

Adjusted Cost Basis Defined

So what exactly is an Adjusted Cost Basis, and why is it important?

Sometimes the power of a word or phrase is derived from its ability to make you question your own assumptions. Just knowing the phrase exists encourages you to entertain different possibilities. In this instance, Adjusted Cost Basis causes you to wonder: Is it possible to adjust the cost basis of your holdings?

The answer is yes.

[Please note - the concept of "adjusted cost basis" is NOT an official tax designation. I have always treated my option income and returns as short term capital gains, but I am not a tax accountant and do not give tax advice other than to recommomend you consult a tax expert to understand the tax implications of trading options.]

Through various conservative option trading techniques, it is not only possible to adjust your cost basis - either on your long term stock holdings, or sometimes even on longer term options (such as LEAPS) that you happen to own - it's actually very easy.

And it probably goes without saying, but I'll state it explicitly - when we're talking about adjusted cost basis, we're talking about adjusting it lower.

How To Lower Your Cost Basis With Options

In a straightforward, plain vanilla, buy and hold world, the only opportunity you get to lower the cost basis on your holdings is to wait for the stock to go down and then buy more shares. Not a particularly savvy way to make money, is it?

But through the strategic use of options, you gain the opportunity to potentially lower your cost basis regardless of market conditions. And that has profound consequences.

An adjusted cost basis that is consistently and incrementally lowered means that you minimize (or even eliminate) losses when your stock trades lower; it means that you generate gains when your stock is flat; and it means that you bank even greater gains when your stock moves higher.

No wonder the phrase is music to my ears.

In short, adopting an adjusted cost basis mindset empowers you to always acquire your stocks for a discount - and then to receive perpetual rebates thereafter.

So how exactly does this work? Let's let at two basic techniques, although these are by no means the only techniques:

Technique #1 - Writing Puts

To review: if you write or sell a naked put, you are essentially offering to buy 100 shares of a stock at a certain price (strike price) between now and the expiration date of the options contract.

In exchange, you receive a set amount of premium, or cash, deposited into your brokerage account.

If the stock closes at expiration above the strike price, the contract expires worthless and the premium you received is yours free and clear.

If the stock closes below the strike price, and you didn't buy the put back to close it out and you didn't roll it out (by repurchasing the put and then reselling another one with a later expiration date), you will be obligated to purchase those 100 shares at the agreed upon price.

The benefit of writing puts to acquire stock is that if you do actually acquire the stock, you're doing so at a lower price (the strike price) than the current price when you initially set up the trade.

But there's another benefit: adjusted cost basis. You're not actually paying the strike price for the stock, but rather the stock price less the total amount of premium you received.

Example: Suppose you were trying to acquire 100 shares of The XYZ Zipper Company for $35/share. Let's assume the following:

• Current share price is $37
• You write a put at the $35 strike price one month out for $1 in premium (i.e. $100 in cash)
• XYZ closes above $35/share
• You continue writing a new $35 put each month and XYZ continues closing above $35/share (with the puts expiring worthless)
• After 9 months of doing this, let's assume you've accumulated, $9/contract in premium (or $900 in cash).
• At the end of month 10, XYZ closes @ $34.50/share and you allow the contract to be assigned to you instead of rolling it out.

On the surface, you paid $35/share for a stock that's now trading at $34.50. Excluding commissions, your cost basis is $35/share.

But your adjusted cost basis takes into consideration all premium you've received to date. The net effect is, excluding commissions, an adjusted cost basis of $26/share ($35 strike price less $9 in accumulated premium).

Technique #2 - Writing Covered Calls

Another technique used to adjust cost basis downward is to write covered calls on stock you already own. Unlike the previous example, you are in effect offering to sell your stock at a higher price by a set date in exchange for premium income.

Covered call writing is a popular method to generate income from your holdings, and there are different approaches to the strategy, from the very conservative to the more aggressive.

Most traders who employ covered call writing strategies do so from the perspective of either generating income on longer term holdings (like generating extra dividends) or as a somewhat safer way to momentum invest (gains are comprised of capital gains plus premium received with the added benefit of the premium received functioning as marginal protection to the downside).

However . . .

By far, the biggest risk for investors who write covered calls on their long term holdings occurs when there's a big move upward on their stock so that it gets called away. If the premium you received is but a fraction of the possible capital gains you missed out on, you're going to be kicking yourself for years to come.

There are more conservative approaches, however, such as a Leveraged Investing covered call writing method detailed in The Essential Leveraged Investing Guide.

Suppose, for example, that you owned shares of The XYZ Zipper Company with an original cost basis of $35/share. And let's also suppose that you adopted a Leveraged Investing approach to your investments to consistently adjust your cost basis lower by just $2 or $3/share per year without putting your shares at significant risk of being called away.

Lowering the cost basis on your holdings by $2-$3/share may not seem like record breaking profits, but accomplishing this year in and year out will have profound consequences. On a percentage basis, each additional $2-$3 you knock off from your original cost basis has a compounding effect. As your cost basis is adjusted lower and lower, each subsequent dollar represents a higher and higher percentage of reduction.

Additionally, over the years as your stock presumably trades higher, it becomes easier and easier to achieve the same premium results, or rather you're able to increase the amount of premium you safely generate and thereby adjust cost basis lower at an accelerating rate.

Final Thoughts

It's a matter of personal preference, of course, whether you choose to consider premium income related to your long term holdings (received either before you acquire those positions or after) as additional income or as a reduction of your cost basis.

The important thing is that you only choose one accounting method, as it were, and that you maintain consistency in doing so.

The other factor is that if you do choose to consider premium income as a technique for adjusted cost basis, it's important that you reinvest the premium received rather than spend it.

You don't have to reinvest in the same stock, but if you spend the premium received you're negating the benefit of lowering your cost basis. You're also lowering the amount of your original investment. And that's no way to grow rich.

For a more extensive illustration of the benefits of an adjusted cost basis, please see the Buy and Hold and Cheat. page.

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