Let’s take a $35 stock with excellent fundamentals and a keen valuation. Buying 100 shares of a company with this share price should be manageable for the majority of investors and traders. I mention the price of the stock at the outset because when we are dealing with a low priced stock, there is so much more you can do with your trading and investing strategies as capital restraint becomes less of a problem. We believe position sizing should be proportional to how one perceives the respective position. If the investment is deemed to be a screaming buy, then by all means, more capital should be put towards that investment.
This is why in our opinion diversifying a portfolio too much is the wrong course of action. Capital should always be tied to the portfolio’s strongest positions. Why? Because over time when pressure comes on the portfolio, it is invariably the weakest position which gets liquidated. Over the years, many investing quotes have stuck with me. Robert kiyosaki for example stated that
There is no such thing as a risky investment but rather a risky investor
Warren Buffett stated that
Diversification is protection against ignorance, It makes little sense if you know what you are doing
So based off the above theme (where it makes sense to back your investments), how can we pick up shares cheaper than the $35 price tag our stock has at present ? Valuation is one thing but decreasing the cost of the shares over time is another potent way of improving one’s probability of having a successful trade/investment. Here is how we would go about it.
The Dividend Yield
The first obvious candidate is the dividend yield. Let’s say that our stock pays a solid 3% yield which works out to be $1.05 based of the $35 share price . If all of this were to go towards the initial cost of the shares (assuming shares were purchased for $35), then the cost basis drops to $33.95. This strategy over time really gets compound interest working for the investor. Furthermore, the compounding seeds can really gain traction when one invests heavily when the stock is trading at the lower end of its range. That is what we have right now in many stocks after the recent downturn in equities which is why investors should be aggressive in picking up solid stocks with strong forward looking fundamentals.
Another strategy is to sell out of the money call options or covered calls against long stock. Many long term investors do not deploy this strategy because they do not want to cap gains due to potentially losing the shares. However, there is plenty of strategies available so one does not have to lose their core position. For example, just say that the company in question had a liquid derivatives market and you were short the $35 regular December call option. Shares would be called away at expiration if price comes in above $35 on the 21st of next month. We discussed though in a recent blog post how one can roll trades forward to avoid assignment (either calls or puts). Furthermore, when the roll is done for a credit, you are consistently improving the initial cost basis of the shares which is the end goal.
Reducing the cost basis can also be done by selling puts when price goes down. At present, implied volatility in a stock such as British American Tobacco (BTI) is slowly coming down from its 40%+ levels ( see below) we had in the front month last week. Target (TGT), although priced higher is another stock where its implied volatility has remained surprisingly high after its recent earnings report. The premium portfolio has positions on in both underlyings. We expect these vol numbers to return to their means over the next few weeks which will mean that both call and put sellers will get paid. Again if sold puts get tested, one can roll out in time for a credit until the trade comes back into profit. When trading in and around a low priced stock with high implied volatility, we always make sure that we have positive deltas to take advantage of any significant upward move. However, the name of the game is to reduce the cost basis of the initial basket of shares. Again put selling is an excellent way to do this in periods of high IV
Source : Interactive Brokers
To sum up, reducing the cost basis of a basket of shares over time is an excellent strategy as it improves one’s chances of having a successful trade. The ultimate goal of any position is to reduce the cost to $0. Then proceeds from dividends and options can be deployed elsewhere.