One of the side benefits of teaching options classes is it continually reinforces to me the power of using derivatives in your investing. Just last night we dove headlong into the mighty covered call strategy, and I got to entertain the crowd with a tantalizing tale of cost basis reduction. As oohs and aahs were heard from all across the room, I thought to myself, “dang, this stuff really is revolutionary.”

Since it’s on the top of my mind, let’s talk about why reducing cost basis is so helpful. First, the phrase “cost basis” is trader-speak for what your breakeven is, or where the stock needs to be above (if you’re long) to grab a profit. If you buy AT&T shares for $32.06, then $32.06 is your cost basis. When the stock price is equal to your cost basis, your odds of success are 50%. Any trick or tactic that can lower your cost basis, then, will necessarily raise your probability of profit.

And who doesn’t like increasing their chance of success? The two simplest ways to accomplish this feat are to sell covered calls or naked puts instead of simply buying stock. Allow me to use AT&T to illustrate. The telecom stock is getting caught up in the consumer staple stock beatdown but is fast approaching a big league support zone (see weekly chart). Additionally, its dividend yield is now perched at a mouth-watering 6.24%. Remember, the lower a stock’s price goes, the higher its yield becomes. Finally, the Stochastic is in deeply oversold territory. The last few times we descended this low were good opportunities for contrarian bullish trades.

Suppose your bottom fishing radar is blaring and you can’t help but grab your pole and cast a line in T here. Do you buy the stock outright or use options to reduce basis?

Reduce basis ya dum-dum. Here’s how it might look.

Step 1: Sell a half-size June $32 put @ 85 cents. This obligates you to buy the stock at a basis of $31.15 which is 2.8% below the current stock price.

Step 2: If the stock falls further, scale-in to the second half of your June $32 puts @ $1.50. This lifts the average credit to $1.175 and pushes the price you’re required to buy the stock at to $30.825 (a 3.7% discount to the current stock price).

Step 3: If assigned, immediately sell ATM or slightly OTM calls. If volatility levels remain firm, you should be able to receive 60 cents to $1.00 for the next month’s covered call (July, in this case). That would drop your basis further to $29.825 (if you receive the $1.00).

Step 4: If the stock continues plumbing the depths, keep selling covered calls to reduce basis further. And don’t forget, you will be getting paid dividends while you wait.

Of course, you may not get to step four. Maybe T bounces hard off of $32 support, and you merely capture profits on the half-size naked put.

Compare this gambit to someone who straight buys T stock here. Seems a far better option, no? As one who constantly preaches the immortality of tradeoffs, I must mention the one drawback to all this basis reduction business: your gains are limited. The one instance where the equity buyer wins is if the stock jets to the moon. Because he has unlimited reward, his profits will keep piling up.

In contrast, once your covered call or naked put hits max profit, you’re tapped out. You may disagree, but I’ll take that trade-off any day of the week. Unlimited profit potential is a carrot mirage anyways.