Buy low, sell high

Stocks A to Z
#23

This is certainly a different terminology. In the US terminology, you booked a capital gain of $990
when you sold 990 shares for $10,890 and the cost basis for the remaining 10 shares comes to $100.

Once again, I’m not talking about tax, I’m talking about economics.
What’s your skin in the game?

For some purposes the weighted average value of all purchases is useful, ignoring any sales.
For other purposes–most–it’s the net of the in-and-out to date: the net amount of money contributed to the position from elsewhere.

For example, say you write a call against some of your stock, turning some of your position into a covered call for a while.
Let’s say that call expires worthless and you pocket the premium as a profit.
For most practical purposes as an investor that’s best viewed as a reduction in your net cost basis.
If there are many transactions over time, I find the net of all of them to be the most meaningful view in terms of tracking an investment.
As mentioned, it’s what you could lose (the net across all purchases and sales through history) if the stock went to zero.
The call in this example wasn’t a different investment, just one variation in the chosen way of holding the single long term exposure.
A very close analogy is the shareholders’ equity figure of a company doing buybacks over time at prices averaging above book value.
Eventually the book per share will turn negative, and for the same reason: that is the net value of share capital contributed to the firm by the set of all shareholders.

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.
A more normal change would be this:
You buy a stock at $70 and write a $100 call for $1 while the stock stays at $90, making your skin in the game drop to $69.

Jim

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#24

Option price fluctuates a lot more than stock price and quite often offers excellent but limited opportunities. For example, I sold BRK-B Jan 2023 $380 call for $19 a few months ago and bought it back for $0.5 a few weeks ago. It’s limited because one would need a lot of cash or stocks to back it up.

#25

I’d like to better understand the role of fluctuating interest rates on the timing of option buys. I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.

You need to read up on the strategy and understand the bit about implied interest rate, which I call pseudo-rate. It’s got nothing to do with normal interest rates.

FWIW, here’s the info for a typical set of these trades I’ve done. As you see, most of them have been around 3%.

Stock      Date      ITM %      rate
BRK.B   06/24/16        -11%    5.20%
BRK.B   11/07/17        -44%    2.40%
XSP     11/09/17        -24%    2.89%
XSP     02/05/18        -20%    3.25%
UNP     10/12/18        -25%    3.45%
BRK.B   02/15/19        -46%    3.79%
BRK.B   08/15/19        -50%    3.52%
SPY     11/01/19        -48%    0.34%
SPY     12/13/19        -31%    0.84%
AAPL    02/05/20        -41%    1.89%
BRK.B   03/02/20        -37%    3.67%
RSP     10/13/20        -21%    2.34%
UNP     10/16/20        -45%    0.85%
AAPL    04/06/21        -56%    0.91%
BRK.B   04/19/21        -39%    2.67%
BRK.B   08/19/21        -30%    3.71%
DLTR    09/03/21        -40%    3.02%
BRK.B   10/18/21        -38%    3.24%
BRK.B   11/18/21        -29%    3.70%
RSP     12/31/21        -30%    1.65%
BRK.B   03/23/22        -26%    5.79%
#26

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

Tom

#27

I thought Jim’s mention of a 6% premium/year on the leverage was referring to this.
…
It’s got nothing to do with normal interest rates…As you see, most of them have been around 3%.

I mentioned 6% just because it’s a conservative estimate to figure out whether an “occasional leverage” strategy would have been a good idea in the past.
You would have done much better than that rate on almost any random date in recent years…so if it works assuming 6%, it definitely would have worked in real life.

Interestingly, the implied interest rates in options are much higher at the moment, but arguably not high enough.
For example, Jan 2024 $165 calls offer 2:1 leverage and cost 6.07%/year in implied interest.
Headline US inflation in the last 12 months has been over 9%.
So, if inflation is 7%/year or more in the next 1.5 years (a big if), the market is paying you to borrow the money to buy Berkshire shares.
On the surface of things, the real interest rate has fallen in the last year or two, not risen.
Unfortunately the definitive answer to that requires knowing the inflation rate in the next year or two, but it’s probably not going to be zero.

Jim

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#28

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

As a general rule when I am holding BRK call options I am also holding shares. If I were to get to expiration and need to inject additional cash to roll the options out into the future my plan would be to sell shares to enable the roll. I can’t think of any time in the last 8-9 years of using options when I have had to sell any shares to cover a roll though.

I did have an instance earlier this year where I was holding a fair number of Jan22 leaps purchased in the spring of 2020 in a taxable account that were deep in the money and facing a large capital gain. Because I’m still a working stiff, I still have cash coming in that I need to allocate occasionally and near expiration I chose to exercise some of the options to hold as shares to avoid capital gains. I tend to think of those shares in my taxable account as going into cold storage and would not plan to sell them to switch to options or cover rolls. I usually have a reasonable cash balance in that account to take advantage of opportunities with BRK options being one of those.

In my tax free accounts I switch between shares and options more frequently but always maintain shares that can be sold to cover any potential rolls needed. It all comes down to what level of overall leverage I’m comfortable with that allows me to sleep at night. Everyone’s risk tolerance will be different.

Jeff

#29

I’m wondering about the need for a cash stash to allow for eventual purchase of a larger number of shares while in option mode.

The ideal is to have a cash stash sufficient to exercise the calls if that becomes necessary.
But if you do keep that cash, then you’re earning nothing on that, so there is no benefit to the occasional leverage, right?

So, let’s say you do not really have the cash that would be required. How risky is that?
It depends on various things.

First, do you think LEAPS might be banned?
I don’t think it’s likely, but it might be up to a 1% chance. Maybe January 2026 LEAPS will never exist. It could happen.
So imagine it is December 2023, your Jan 2024 calls are about to expire, and the Berkshire price is very low, and there are no newer option contracts available.
You might have to close our position at a big loss if you can’t roll them out.
You have to be able to live with this: either have another source of funds to exercise the calls (as you mention),
or live with the risk of losing money–possibly up to the entire value of your calls.

There are ways to reduce the risk further, though not reducing it to zero without the cash needed to exercise:

Don’t have everything expiring at the same time.
The price might be arbitrarily low on any given date, but the chances of it being arbitrarily low continuously for a year or more are considerably lower.

Pick very low strikes. You might lose the same dollar value per share that the price of the share falls, but it’s very much less likely you will go to zero.

Even if you don’t have a way to come up with the cash to exercise your calls, make sure you have at
least a smallish cash stash: if you can roll, it will cost you a little extra money.

Don’t roll at the last minute…roll as soon as you can, preferably when the stock price is reasonably high.
If you can roll on any date that the price is not unreasonably low, do so: if that opportunity arises,
this preempts the possibility of having to roll when it is too low to roll, later on.
You don’t want to be in t he situation of having no choice of dates because the expiry date is looming.

Use the longest dated, lowest strike calls you can. This gives time for value to work out, and gives you more choices of dates to roll.
When the odds are very good, even a tiny bit of leverage will turn a pleasant rate of return into a wonderful rate of return.

Enter leveraged call positions only when the valuation is very attractive, so that the odds of the price being lower at expiry become much more remote.
If you buy at book value today, realistically, what are the chances that the stock price will be lower in a couple of years?
It could still happen, but it becomes less and less likely depending on the valuation multiple the day you start.

Let’s say everything has gone against you: the expiry date is looming and the stock price is very low.
The market value of your existing calls is very low, and you don’t want to lock in that loss.
If you have both cash and calls, you can raise money by selling stock and buying a lot of VERY low strike calls.
The money raised can be used to replace both your stock and your about-to-expire calls, also at a very low strike.
This isn’t free, but it’s much better than letting calls expire when the stock price is temporarily low.
For someone willing to consider calls, plain stock can be thought of as a last-ditch source of funds.

But ultimately, this is not a risk free strategy if you do not have a way to raise the cash needed to exercise the calls.
Having some ace in the hole is always a nice idea. For example, I have an unused HELOC.

Personally, I tend to keep some calls even when I have a pile of cash.
(Flipped around, I tend to keep a pile of cash when I have calls)
This doesn’t maximize my returns…I’m wasting some of the cost of the leverage. I could simply have stock and less cash, more cheaply, right?
But cash has so many possible uses, I find it worthwhile for the optionality.
Sometimes in the distant past Mr Buffett would have Berkshire borrow money when it wasn’t needed, but cheap.
He said it makes sense to get the money when it’s easy, because when it’s useful it isn’t always available so easily.

Jim

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#30

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.

Each of us are free to choose anyway we want to account for the “cost” of our shares, but IMO this is not the the correct way to look at gains/losses irrespective of the underlying taxes levied on gains. And with taxes most of us have to pay outside your residential jurisdiction, it is definitely not the correct way to look at things. Let me provide another example where the distinction is not minor. Let us say I bought 2,000 shares of a stock for $20,000. The shares went up and now trade for 4X what I paid for and my 2,000 shares are worth $80,000 now. I then sell 1,000 shares for $40,000 and in your terminology/methodology the cost basis of the remaining 1,000 shares is -$20,000. Whereas using the “standard” terminology/method, the cost basis of remaining shares is $10,000 (with a realized gain of $30,000).

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#31

The ideal is to have a cash stash sufficient to exercise the calls if that becomes necessary.
But if you do keep that cash, then you’re earning nothing on that, so there is no benefit to the occasional leverage, right?

So, let’s say you do not really have the cash that would be required. How risky is that?
It depends on various things.

Many thanks for your elucidation of this, Jim. I’m in the camp of being highly intrigued with the prospect of enhancing my investment returns through the judicious use of options, but I’m still trying to sweep away the remaining cobwebs from my understanding of this (to me) very complex process. Your explications are most helpful in that endeavor.

Tom

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#32

It seems like an absurd view because in my case the number has gone negative.
Usually the distinction is minor.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Each of us are free to choose anyway we want to account for the “cost” of our shares, but IMO this is not the the correct way to look at gains/losses irrespective of the underlying taxes levied on gains. And with taxes most of us have to pay outside your residential jurisdiction, it is definitely not the correct way to look at things.

I’ve been going back and forth on my own accounting for this situation.

Amidst the Covid panic I sold a lot, but not all of my BRK holding, my largest in a taxable US account, in accordance with first-in-first-out precedence. Three weeks later I bought back in, realizing that I’d allowed the fear induced by this extraordinary macro phenomenon to inappropriately drive my sale. So my sale and repurchase prices were roughly similar. However, in the process I incurred a substantial capital gains tax on the sale of my long-held BRK shares.

So I then faced a need to appropriately account for the cost of my present BRK holdings. Given the substantial gains I’d realized on the sale, this initially resulted in a negative cost basis for currently held shares, which I intuitively felt was inappropriate.

So I’ve been puzzling over this ever since. Any illuminations on this dilemma are most welcome.

Tom

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#33

I don’t wee why this is creating a bit of a stir.

If I trade around a position I add any gains or losses into my current cost of goods. This includes sold puts and calls that expire worthless.

I recently bought apple for $138. Then sold some naked puts instead of increasing the position at $105. When and if they expire worthless I will net the gain out of my $138 cost.

I sold some BRK in the $350 earlier in the year and bought them back in the $320’s. I adjust my carry to reflect the sell gain and the buyback.

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#34

I adjust my carry to reflect the sell gain and the buyback.

You can take your trading profits/ losses and assign anywhere mentally. The cost of the shares you own has a legal definition and it has real world consequences like taxes.

If you own in IRA, you can avoid taxes. Foreign non-resident aliens don’t incur us capital gains tax, however are subject to dividends. So it is natural some folks don’t like dividends. Tax codes have their own logic!

#35

I’ve been going back and forth on my own accounting for this situation…

It just depends what meaning you want from your calculation.
Different purposes suit different calculations.

Here’s one question that is of interest to me, as an investor:
Imagine somebody has a position in some stock, with some history of purchases and partial sales.
If they finally close that position today for proceeds of $10000, what is the final end-to-end profit on the stake since the very beginning?
After all the to and fro, what’s the bottom line at the end? Certainly a meaningful question.
That will be $10k minus whatever they have put into the the position, net, to date.
i.e., ($10k) - (the cost of all purchase to date) + (the sum of all sales proceeds to date).
The last two, the “net money in the position today”, can definitely be negative.
It’s common (and desirable!) for realized profits to date to exceed current market value.
That’s the situation I mentioned in the OP.
Anyone having reached that situation can’t have an end-to-end loss when the position is closed.
(unless perhaps they subsequently buy lots more at a high price and sell everything at a very low price)

Another commonly calculated number is the weighted average cost per share of all purchases since the share count was zero, ignoring any sales.
(That’s the cost basis for tax purposes in many countries, for example–the US seems to be an outlier).
I don’t find this number as interesting, as a position might have become big and small many times,
at a wide variety of price points through history.
Imagine I buy 100 shares at $20, sell half at $50, buy them back at $35, sell half at $65, buy them
back at $50, sell half at $80, buy them back at at $65, sell half at $95, and buy them back at $80.
I have the same 100 share position I started with at $20, and I have been doing very well overall,
but does the weighted average buy price of $45 have much meaning to me as an investor? It’s not obvious.
If the stock went to zero I’d still have an overall profit, not a loss of $45 per share, nor even $20 per share.
In this particular instance, it’s probably best thought of as two separate investments:
A long term block of 100 shares purchased at $20, and a separate bunch of short term trades showing an overall net profit of $3000.

The companion number is the weighted average sale price to date. ($72.50 in the example above).
You definitely want that to be higher than the first one.
The difference is the profit per share realized to date on whatever number of shares have been round tripped.
But other than that insight I don’t see a whole lot of use for it.

By far the most important number for me in evaluating the success of a stake is tracking the rate of return as a function of the capital at risk.
Profit is what you want, and putting capital at risk for a finite time stretch is the thing you are bringing to the party to accomplish that.
For each day, what would I lose if the price went permanently to zero? Sum all those daily figures to get a total number of dollar-days at risk.
I calculate my total profit to date, and divide that by the dollar-days at risk to get a rate of return on capital.
If that number is good, you are a good investor.
This is a good metric to see how well you are doing at dynamic position sizing: you want a lot of
capital in a position in the (probably) good stretches and little during the (Probably) bad stretches.

Digression:
Personally I find it most meaningful to calculate the “what would I lose” as “how much worse off
would I be compared to the situation the last time I resized or considered resizing the position”.
Imagine I buy a block of stock at $100.
I go on holiday for two weeks, and unknown to me the price hits $200 for most of that time.
I come back, and it’s (say) $121.
For this entire stretch I deem my capital at risk to have been $100 on each day: that’s what I brought to the party and put at risk in the position.
Viewing this interval as a standalone investment decision, $100 was my cost basis, what I decided to risk.
To me, it doesn’t make sense to view it has having had $200 at risk one week into my vacation.
I never had that $200 in hand, and I never decided to allocate it to anything, so it offers no insight into how well I have been allocating what I have in hand.
Imagine further that I sell at $121 on my return.
I’m not fond of the traditional internal rate of return calculation method, which (if you think about it)
implicitly assumes that the capital at risk was $110 half way through my vacation.
That is neither the capital I put at risk into the position for that interval, nor the market price at that intermediate moment.

Jim

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#36

You can take your trading profits/ losses and assign anywhere mentally. The cost of the shares you own has a legal definition and it has real world consequences like taxes.

This is a key point. You can think of it however you want, but the government has the power to enforce how THEY think of it. The government doesn’t care how you think of it.

I adjust my carry to reflect the sell gain and the buyback.

Why? What purpose does that serve? What if instead of sell BRK and then buy BRK, you sold BRK and then bought ABC. Nobody thinks that you would “adjust” your carry of ABC.

Each buy/sell transaction stands on its own. Anyway, assuming you had a gain on the BRK that you sold…all you did was pay the tax now instead of later.

3 Likes
#37

You can take your trading profits/ losses and assign anywhere mentally. The cost of the shares you
own has a legal definition and it has real world consequences like taxes.
…
This is a key point. You can think of it however you want, but the government has the power to
enforce how THEY think of it. The government doesn’t care how you think of it.

Yes, but this is a thread about how to evaluate investment performance in the most meaningful ways.
It’s not a thread about tax calculation.

Jim

11 Likes
#38

It just depends what meaning you want from your calculation.
Different purposes suit different calculations.

Thanks again Jim for a nice discussion of the issue. I agree with your perspective on this, yet am inclined to adjust the aggregate return to date for a given holding as ultimately being net of taxes incurred by virtue of intermediate trades.

Taxes, of course, vary by jurisdiction and, at least here in the US, the type of account a position is held in. In a SEP-IRA ordinary taxes are incurred on account withdrawals, which can be reduced to mandated annual distributions, often requiring the liquidation of some holding … ideally at an opportune price point. In a normally taxed account, taxes are payable annually on liquidations at either a capital gains rate or an ordinary rate, depending upon holding period. I’m sure everyone knows all this, so this is just my thinking out loud.

The point is that investment strategies are appropriately influenced by anticipated tax outcomes, regardless of the means by which those taxes may eventually be paid. So I’m inclined to factor taxation into my reckoning of investment returns.

Tom

#39

Yes, but this is a thread about how to evaluate investment performance in the most meaningful ways.
It’s not a thread about tax calculation.

May be. The fact that foreign nationals are not taxed on capital gains, certainly helps. It has a meaningful way of altering how you look at your numbers, when you have to fork out 30% or how often you can do some of these transactions to boost the results.

Separately, when it is time to retire and cash out, probably forgoing US citizenship and moving to low/no tax heavens and cash out, then come back and regain citizenship may be worth investigating.

#40

…am inclined to adjust the aggregate return to date for a given holding as ultimately being net of taxes incurred by virtue of intermediate trades.

That makes perfect sense to me.
And every transaction should include the drag from commissions.
If you borrowed money to enter the position (not advised!), it should include the interest as well.

My own tracking spreadsheet for Berkshire is conservative in all those ways, and one more:
My main calculation penalizes my returns for the cost of the implied interest built into call options,
(every entry price is tracked as strike+cost of call, not market price),
but I track the portfolio value based on the nominal value of the shareholding, meaning it doesn’t include the corresponding benefit of the leverage.

I also have a calculation for the leveraged returns, which I’ve posted once or twice, but I try not to look at it too much.
That sort of thing can make greed overwhelm prudence.

I can’t honestly say that using the leverage built into calls is a very good idea.
The best I can say is that it has worked for me…so far. Imagine scary music as the backdrop to those last two words.
But if you’re going to succumb to the temptation, always think of it merely as a short term loan:
always assume that you’re going to exercise the options near expiry and switch to plain unleveraged stock at that time.
This gives you a much more prudent mindset than the often bizarre results you get looking at percentage return on the cost of the option.

Jim

3 Likes
#41

Yes, but this is a thread about how to evaluate investment performance in the most meaningful ways

No, it is not. Taking a trading profit and assigning it to an investment and saying that investment returns are higher doesn’t really add up either in real world or even looking at the performance of an investment.

These are mental models to cheat oneself. We all indulge in that. I am guilty of it too. I am owning Intel (a very small position) for many years. The stock performance is nothing to write about. However, I do covered call, sometimes opportunistically trade, etc. So in my mental ledger Intel is a decent profitable position. But that is not because Intel as the company has executed well, or the stock has done well, but I was lucky with my trading.

Making trading profits doesn’t make your original investment price low. Period. One can argue, I am leveraging my knowledge of the company I own to trade on the name while retaining the core position. But that is something most investors do all the time.

Really nothing to see here.

2 Likes
#42

Hey Jim, like many I do enjoy your spreadsheets being a fan of a trusty.xlsx also myself every now and again. On your latest trade system…

Since 1998 this would have resulted in the following trades:
Add leverage 2000-01-31 at price 51200 and P/B 1.341
Remove leverage 2000-04-20 at price 59700 and P/B 1.563
Add leverage 2008-10-27 at price 105126 and P/B 1.348
Remove leverage 2014-12-02 at price 224805 and P/B 1.555
Add leverage 2015-08-21 at price 201330 and P/B 1.345
Remove leverage 2017-02-22 at price 254415 and P/B 1.553
Add leverage 2018-05-29 at price 284805 and P/B 1.345
Remove leverage 2022-03-24 at price 528555 and P/B 1.555
Add leverage 2022-05-12 at price 462090 and P/B 1.338
Holding leverage 2022-07-29 at price 450900 and P/B 1.305

…I noticed there was no ADD during the mid-March 2020 pandemic BRK smack-down. Why not?

Thanks, L