Lowering Cost Basis
Options are priced based on a complex formula that was developed by Nobel Prize winners. Volatility is a component of the formula, and option prices are higher when volatility is high and lower when volatility is low. In the last four months of 2011, stock markets around the world were extremely volatile, and the Dow Jones U.S. REIT Index was no exception. While the index posted wild monthly swings its total return was only 1.54 percent (including dividends) for the last four months of the year.
We have the ability to generate reports by security which account for the effect of call premiums and dividends collected. The report lowers the cost basis of a position and calculates return based on the adjusted basis versus the market price of the underlying or strike price of the most recent option sold, whichever is lower. While there is always an element of luck in the timing of trades—sometimes in our favor and sometimes not—below is an example of trading in a Real Estate Investment Trust ETF that occurred across multiple accounts during the last four months of the year:
While the market price of the ETF is only marginally higher that the purchase price on Sept. 1, the high option premiums collected made the position much more profitable than simply buying and holding the ETF.