In the comment section of one of my recent articles, the discussion turned to how to turn around the situation when a stock you hold has had a significant drop in price, putting you deeply in the red. A response by spindr0, who is an excellent source of knowledge on option, brought up a method called the Repair Strategy. How this strategy works is that you buy a call which is ATM (at or very near the current market price of the stock) and write to calls at a strike price is half way between the current market price and your cost basis. The idea is that the cost to buy the ATM call will be covered (or nearly so) by the premium received from writing the two OTM calls. Since the cost is fairly small, you take very little risk, just the amount of money to cover the net debit in the transaction (if any) and get a chance to exit your position with no loss.
That discussion got me to thinking more generally about how an investor could use call option contracts to help lower the cost basis for a stock that had suffered a decline in position but that the investor expected to have the price recover in the future. I came up with 4 ways to use call option contracts to help reduce the cost basis of a position (none of the methods requires that the stock have had a price drop in the past, just that the investor wants a lower cost basis or to sell it for higher than the market value). Also, none of these methods are automatically 1 and done, an investor can based on market conditions choose one of them, and then later switch out to a different one (due to either the option contracts expiring or closing out the option positions early).
Kinder Morgan (NYSE:KMI) is a stock that was once held in high regard by those interested in collecting high and growing dividends. I don't need to rehash the problems it got into, the dramatic fall in share price and the dividend cut. I find myself with a significant position in KMI (600 shares) that is now deeply underwater, my cost basis being about $30. Articles like this, along with the possibility that oil prices will rise, point to the potential that the price of KMI stock will increase. This article, by Albert Alfonso, also makes the case that KMI is repairing its balance sheet and might begin increasing dividends in the not too distant future. Based on those and similar articles, I think a modest increase in the share price of KMI is likely in the near future. Each of the 4 methods explained in this article require at least a moderate increase in share price to work well. Since I have such a large position, especially with the reduced dividend, I would very much like to reduce my exposure and put that cash to more productive uses. I don't want to sell the whole position, but if I can get a reasonable price I would like to sell a couple of hundred shares.
In this article I will continue to use all the terms for option contracts I defined in this article. In addition, when I talk about buying a call, I mean that the investor will pay the premium for a contract where they have purchased the right to purchase 100 shares of company stock at a price equal to the strike price at any time on or before the market close on the expiration date. When I talk about selling a call, I mean that the investor will sell a contract they previously bought at a time before the contract expires.
The Repair Strategy
First, let's explore how to use the Repair Strategy. What we want to do is go out about 3 months, to give KMI enough time to rise in price. Given the current market price, we will want to buy a call with a strike of $22 and write two contracts with a strike $26 (because we want the strike price to be half the distance between the $30 we want to get for our shares and the $22 we will get for the shares the call we bought will cost us). So let's look at the call chain for the December expiration.
So for every hundred shares of KMI we want to fix, we need to buy a $22 call at a total contract price of $70 and write two $26 calls to get a premium of $14 each, or a net debit (ignoring commissions) of $18. So if KMI closed above $26 at market close on December 16 th, we would collect an extra $4 a share beyond the $26 that would be received for the shares called away. Of course in order for this to work, all the options in the transaction would have to expire ITM, so what are the chances of this working is based on KMI trading above $26 on December 16 th. Let's look at the details of that contract and see what our chances look like. The Delta for that contract is 0.12, or a 12% chance of it getting exercised. For me, that means I have to spend about $40 or so to have a 12% chance of breaking even. Each investor will have to determine if it's worth it for them (and if you pay lower commissions that I do it very well might be), but let's look further out in time.
Looking at contracts where the expiration date is further out, the net debit for the Recovery Strategy shifts around between about $15 and $40 (plus commissions) and the Delta for the higher strike contracts never gets about 20%.
Due to the fact that 3 contracts are required for each 100 shares of KMI, this method is more expensive to close out early, so it will often work best if it's the last method you use.
Write a call with a $30 strike price
The next option is to just keep it very simple and write a call with a strike price of $30. This is a pretty simple method, as you only write one contract, and then you either get back you $30 cost basis or you don't. This method doesn't use the leverage that options can give you that the Repair Strategy is based around. But it doesn't have any more risk than just holding till the market price reaches $30, and it does give you a little more cash. Looking at the various option chains, the first expiration date that I see a reasonable premium for a $30 strike is the January 2018 contract.
Drilling down into the details of that contract, shows that the Delta is just 0.20. Just a 20% chance of getting the $30 seems long odds to me, but again, an investor will have to decide if that is worth it.
Write a call, premium reduces your basis
A more complex method is to write a call, and use the premium to reduce your cost basis. You repeat this method over time until you cost basis reaches the market price. This method is one of the most flexible methods and requires the least help from the market. For this method to work, you just need the market price of the stock not to reach the strike price on the current iteration.
What you want to look for is an expiration date a couple of months down the road with a strike price that isn't likely to be seen in that time frame. I think it unlikely that KMI will trade about $25 before they report their earnings in February, so I will look at the $25 strike for January 2017.
Looking at that contract, it pays a premium of $0.27 and has a Delta of 0.18. That gives me about a dividend worth of premium with 3 months till expiration. There is also enough of a premium that depending on price action, I have room to buy it back in late December at a still reasonable profit.
So once this position closes, then the investor reevaluates the prospects of each method, and chooses the one that makes sense at that time.
Buy a call, sell it back later to reduce basis
This method works very similarly to the last method, except you buy a call contract rather than sell to open the position. How you get money to reduce your cash flow is that you sell the contract before it expires for more than you paid for it. So for this method, you will have to shell out some extra cash to get started. And you will need the market price of KMI to increase, the more the better. This is different that when you write a call where you want the market price to stay below the strike price.
Looking at the call chains, you want to select next month (if you can get the other things you need). And you want a strike price that it's reasonable to expect KMI to reach. Either the $22 or $23 strike might be suitable, so then go look at the details.
Looking at the details for the $22 contract, you want Delta below 0.30 but the strike price such that it's likely that KMI will be at or above this come November. All things considered, the $22 looks like the better choice to me, but the $23 could work as well. It all depends on how much you think KMI will be selling for in January. I think there is a good chance that it could be trading between $22 and $23 then, so that would make the $22 option the better choice.
Once you have purchased your call options, you then wait for a while. Keep an eye on the price of KMI, if you get a big pop, look to selling the option then. Even a gradual increase in the price can work to your advantage. Even if KMI only goes up a dollar or so, you should be able to sell the option back at a profit.
I have used some of these methods on KMI to help lower my cost basis, below is a list from my broker of my current positions for KMI options (these are all covered calls as can be seen that the market value is negative).
As I said earlier, I have 600 shares of KMI (when I go all in and am wrong, I really go all in!). So I have several different strategies working at the same time.
The big thing to keep in mind is that you have lots of choices, and you don't have to make them right now. If the numbers don't make sense for you to do, wait till tomorrow or even next week. It often takes far longer to get out of a hole than it does to fall into it.
Don't worry if just one application of any of these methods won't get you all the way out of the hole, they lend themselves to being repeated (especially the last 2). Patience and calming accessing the probabilities will pay off in the end.
Disclosure: I am/we are long KMI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have multiple call option contracts open for KMI.