How Do Hedge Funds Maintain a Low Cost Basis in Their Long-Term Holdings?

In the world of investing, understanding how large players like hedge funds acquire stocks at a low cost basis is crucial for individual investors looking to improve their strategies. This article will delve into the concept of cost basis, the role of in-the-money (ITM) options, and whether exercising deep ITM options can be a wise decision.

What is Cost Basis?

Cost basis refers to the original value of an asset (usually the purchase price) for tax purposes, which is used to calculate capital gains or losses when the asset is sold. In other words, it’s the amount an investor has invested in a stock before any appreciation or depreciation in its value. A lower cost basis can lead to reduced capital gains tax liabilities.

The Role of ITM Options

In-the-money (ITM) options provide the holder with the right to buy or sell an asset at a predetermined price that is favorable when compared to the current market price. For example, if an investor holds a call option to purchase shares of Apple (AAPL) at $150, and the current market price is$170, the option is considered ITM. Investors often use these options to gain advantageous entry points into stocks without incurring the full cost of purchasing the shares outright.

Exercising ITM Options vs. Selling Them

While ITM options can be exercised for stock acquisition, many large investors often choose to sell their options rather than exercising them. Here’s why:

1. Retaining Extrinsic Value: When options are sold rather than exercised, the investor retains any extrinsic (time) value that could still be present. Exercising options eliminates this remaining value, which can be particularly significant if the options have considerable time until expiration.

2. Potential for Greater Returns: Selling the option can yield a larger profit as it allows investors to benefit from the entire premium received rather than just the intrinsic value of the option.

3. Strategic Capital Management: Hedge funds are adept at managing their capital. By opting to sell instead of exercising, they may find other investment opportunities or maintain liquidity for volatility or market corrections.

Should You Exercise Deep ITM Options?

Let’s consider a scenario where you want to acquire shares of AAPL at $150, a price significantly lower than its current market value of, say,$170. Here are factors to consider:

1. Assess Extrinsic Value: If the option has substantial extrinsic value, exercising may not be the best choice. For example, if the option’s premium includes $20 of extrinsic value, selling the option may yield a$20 profit per share instead.

2. Capital Requirements: Exercising a call option requires capital—specifically the total cost equal to the strike price multiplied by the number of shares. For Apple, if you wish to exercise options to buy 10 shares at $150, you need to allocate$1,500 for that purchase.

3. Market Outlook: If you believe that AAPL will continue to rise significantly, it may be advantageous to exercise and hold the stock. Conversely, if you think the market may fluctuate or decline, it could be more prudent to sell the options and lock in profits.

4. Long-Term Investment Goals: Assess whether owning shares at $150 aligns with your long-term investment goals. If it does, and you trust in the company’s growth trajectory, exercising the option could be beneficial.

Example Calculation

Let’s put some numbers into perspective:

• Current AAPL price: $170
• Your option strike price: $150
• Number of Shares: 10
• Premium of option: $30 per share (including$20 extrinsic value).
• Cost to exercise: $1500 (10 shares x$150).
• Intrinsic value (profit if exercised immediately): $200 (10 shares x ($170 - $150)).

If you exercise:

• You pay $1,500 for 10 shares of AAPL at$150, facing a market value of $1,700. Your profit is$200.

If you sell the option:

• You would receive $300 (10 shares x$30 premium).

In conclusion, whether to exercise deep ITM options or sell them is contingent upon various factors including market expectations, financial goals, and capital availability. This strategic consideration is fundamental in maintaining a low cost basis and maximizing your portfolio growth.

Conclusion

Understanding how hedge funds and institutional investors lower their cost basis through various strategies—including ITM options—can provide valuable insights for individual investors. WealthBee, with its robust data analysis and trading journaling capabilities, can help you track and analyze your trades effectively, ensuring you make informed decisions that align with your investment goals. Remember, always evaluate your personal financial situation and long-term strategy when managing your investments.