Improving Cost Basis using ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO) and Proshares Trust II (NYSEARCA:SCO)
The practice of improving cost basis is powerful but something that most individual investors don't recognize, and most institutional investors don't utilize. I have found this method of improving cost basis to be extremely powerful but it is restricted to the use of leveraged ETFs.
In this example I will discuss the practice of improving cost basis in our ProShares Ultra DJ-UBS Crude Oil (NYSEARCA:UCO) position using and Proshares Trust II (NYSEARCA:SCO) a real life example with real life intentions and objectives.
First, it is my opinion that oil prices will trend higher over time, and if that is true we want to maintain a net long bias, which means that we want to own UCO when the dust settles, especially from our lower price points, but we also recognize that volatility exists in this space and with that comes the opportunity to improve cost basis, so for traders that spells opportunity.
For sake of this example let's assume that you had owned 10,000 shares of UCO at $8.00 a share.
Last Friday I made a recommendation whose objective was to improve cost basis in that UCO position, and it worked largely like this.
- First we sell the UCO position,
- Then buy SCO with the proceeds
- And hold that SCO position until such time as it is time to convert back to UCO.
- We need to determine when that is.
By doing this, two things happen:
- we make money from SCO
- We avoid drawdowns in UCO
Intention: the understanding was that UCO will likely fall (oil would fall from Friday's levels), and if that's true SCO would likely increase because these two ETFs are designed to move in the exact opposite direction of each other.
It's important to recognize that this practice of improving cost basis only works with ETFs that have exact opposite characteristics like these do. Other examples could be SSO and SDS, DDM and DXD, QLD and QID, and UWM and TWM. Our focus here is on oil, and the ETF combination that we are using can be used to improve cost basis.
When we sell UCO we remove the risk associated with a decline in price. I recommended doing so at just above $11.00 per share, and at the time I was writing this UCO was trading at about $9.9, roughly 10% lower than the sell. Because we no longer own UCO we avoided that decline in our asset price and now reasonably we could buy back the position at a 10% discount if we wanted to. Or, buy 10% more shares.
However, we also bought SCO at that same time and it is up about 10% from our purchase price too, so not only did we avoid a 10% decline in the price of UCO, but we also have an unrealized gain of about 10% from SCO, for a total of 20%.
That's right; we actually have a cost basis improvement of double the avoided drawdown.
So, in our example, we could buy back 12,000 shares of UCO and own 20% more than we did last Friday. That is a huge added value. Think about this very carefully. There was a period of time in 2011 when I used this practice to improve costs basis by 1% per day every day for 20 days in a row in UWM during a very hectic market environment, so it can be used to mitigate the impact of market drawdowns too.