Tales of a Technician: What is Cost Basis?
April 18, 2022
There’s a language barrier that can be steep when you enter the financial markets. The highfalutin vocabulary can make things seem far more complicated than they really are. The gatekeepers and entrenched interests like this. It keeps the riff-raff out while making the public more willing to pay others to invest their money.
One of our goals at Tackle Trading is to demystify the markets by making the unknown known and the complex simple.
Take the term “cost basis,” for instance. What does it mean?
- It’s the price you paid for something.
- It’s your breakeven.
- It’s the price you would have to sell that something for to recoup your original investment.
- It’s sometimes referred to simply as “basis.”
Here are a few examples.
Single Purchase
I bought 100 shares of Disney for $130. My cost basis is $130.
I bought a call option for $5.00. My cost basis is $5 per share or $500 per contract.
I bought a house for $300k. My cost basis or basis is $300k.
Multiple Purchases
I bought 100 shares of Disney for $130. My cost basis is $130. The stock then fell to $100 and I purchased another 100 shares. In doing so, I reduced my basis from $130 to $115.
I bought a call option for $5.00. My cost basis is $5 per share or $500 per contract. The stock price climbed and I wanted to buy another call option to increase my size. The second contract cost $7. That increased my cost basis from $5 to $6 per share or $500 to $600 per contract.
If your second purchase is higher than your first, then it increases your cost basis.
If your second purchase is lower than your first, then it decreases your cost basis.
Covered Calls
I bought 100 shares of Disney for $130, then I sold a one-month $135 strike call for $3. The $3 premium received reduces my overall cost basis from $130 to $127. One month later the call expires and I sell a new one-month call for another $3. This time the stock rises aggressively and my call moves in the money. Rather than allowing assignment, I buy back the call for $5, thus incurring a $2 loss on the call. This loss increases my cost basis on the stock from $127 to $129.
When you make money on the short call portion of your covered call, it reduces your cost basis on the stock.
When you lose money on the short call portion of your covered call, it increases your cost basis on the stock.
Naked Put
AMD is at $90 and I sell an $80 naked put for $1. What is my basis in the put? Answer: $1.
The put obligates me to buy 100 shares of AMD for $80 at expiration. But, I received a $1 premium for selling the put. If I end up getting assigned at expiration (thus having to buy shares), then what is my cost basis in the stock? Answer: $79. I purchased the stock for $80, but the $1 premium reduces the basis to $79.
Note that any time I used the word “cost basis” in the above paragraph, I could have instead said “breakeven.”
What of Probability?
Now, what does cost basis have to do with the probability of profit?
Any time you reduce your cost basis when you’re purchasing an asset (stock or option), you simultaneously increase your probability of profit.
- Trader A buys 100 shares of stock at $50.
- Trader B buys 100 shares of stock at $50, then sells a $55-strike call for $2, thus reducing his cost basis from $50 to $48.
Which trader has a higher probability of profit?
Trader B because the stock only needs to be above $48 and he’ll make a profit at expiration. In contrast, Trader A needs the stock above $50.
Here’s another one.
- Trader B buys 100 shares of stock at $50, then sells a $55-strike call for $2, thus reducing his cost basis from $50 to $48.
- Trader C sells a $45 naked put for $1. If he gets assigned and buys shares his cost basis will be $44.
Who has a higher probability of profit?
Trader C!
Now, between Trader A, B, and C, who has the most potential profit available?
Trader A.
This illustrates you don’t get something for nothing. In exchange for reducing cost basis and increasing the probability of profit, you simultaneously reduce how much potential profit there is.
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