ERICOPOLY

Yes, a floor gets established for the value of the premium in the call with no dividend protection. Only, the floor will be $0. The premium won't fall below $0, because of the arbitrage. Once the dividend is large enough, there will be negative utility to own the call. At that point, the best strategy would be to exercise the call and grab the dividend (or sell it back to the market for someone else to do this arbitrage). So the floor in the calls for the option premium is $0 if there is no dividend protection. The premium also can't go negative due to arbitrage. You can think of a 100% dividend to imagine this clearly -- even though it's not a realistic example for an ordinary dividend. So yes, you are right. At a certain point the floor for cost of leverage (after premium goes to $0) will be just the cost of not getting the dividend.

actually, i need to think more about my last post. i believe it may be that the cost of lost dividend is actually a cost on what is actually borrowed after taking into consideration all that prepaid warrant premium. incidentally, i also worked out wahat madonnas "like a prayer" is about. hot damn that's funny. think of tarantino in reservoir dogs when he explains the meaning of "like a virgin" and this is my first post using my big TESLA computer screen -- i'm charging at the tesla supercharger at SpaceX

Previously I put forth my method of computing cost of leverage -- the first part of the calculation was calculating how much is actually being borrowed (it's convoluted because you are prepaying interest to the very person you are borrowing from). But that of course wasn't the full cost of leverage, it was just the cost of the option premium component. Missing is the cost of the excluded dividend (if any). Because this portion of the cost isn't payable upfront, it's cost can just be added to the result of the prior calculation. So a $1 dividend declared in a given year will cost 5% at $20 strike, it will cost 10% at $10 strike, and it will cost 100% at $1 strike. Pretty funny isn't it. Dividends make the leverage costs soar when the strike is lower. So there is a point where the low strike options start to cost more than the at-the-money strike options. Even though the at-the-money strike options are lower risk in a sizable common stock price decline (due to the higher put strike).

ordinary dividend: COMMON STOCK: Stock trades at $36. $1.08 ordinary dividend is declared. Stock now trades at $34.92 on dividend-EX date. $1.08 + $34.92 = $36 WARRANT/CALL: Option trades at $18 $1.08 ordinary dividend is declared Option now trades at $16.92 on dividend-EX date (because the stock dropped by $1.08 on div-EX dates) Better example? Value of common stock portfolio didn't change one bit. Value of option/warrant portfolio DECLINED by 6% That 6% decline happens to be TWICE the dividend yield.

Yes you are comparing that vehicle. Because it's 2x in the case of the special dividend, as well it should be 2x for the ordinary dividend as well -- were it not for the cost that also is 2x in size.

The condensed version is this: The warrant holder enjoys TWICE the yield of a special dividend (compared to the unleveraged common stock investor) The warrant holder similarly should enjoy TWICE the yield of an ordinary dividend (compared to the unleveraged common). But he instead gets ZERO yield -- therefore, there must be an offsetting cost eating it completely up. Thus, this cost must be equivalent to TWICE the yield of the ordinary common shares. Let X = cost 6% - X = 0

It is a cost. But, in my comparison, the total return of the common is what defines that cost. The math of the common total return indicates a loss of only the dividend yield. If I compared a vehicle that did get the dividend yield, then it would get 2x the dividend, as you say, but I am not comparing that vehicle. Why don't you run the calculation again, but this time do it for the special dividend? You will wind up with twice the return for the warrant versus the common. Agreed?

Is not being entitled to a regular dividend a cost or a benefit? It can be written in a contract like you say, or it can be on a cave wall, or on a golden tablet, or it can be written on the Rosetta Stone. Regardless, it's either a cost or a benefit.

How come the expected return from a $20 increase in stock price is higher in one vehicle versus the other, if you only have $18 invested in each one? I'm sure you will agree that it's because you are leveraged to twice as many underlying shares. Then why don't you agree that you are also leveraged to twice as many dividend payments? Only, you are getting none of them :( You seem to believe that you are entitled to twice as much upside in stock price (even though you only have the cash for half that much), but not twice as much dividend. Why the distinction?

Oh yeah, and forgot this really obvious one... The call options only miss out on regular dividends. Special dividends result in an option strike adjustment. And that option strike adjustment on the special dividend amounts to TWICE the economic value that you would enjoy if you just had your $18 invested in the vanilla common stock. So if call options can have TWICE the profit of earning a special dividend, why can't they have twice the COST of missing a regular dividend? What do you say?

You are unable to borrow money to leverage your equity? I don't see why. What would it cost to purchase an out-of-the-money $18 strike protective put (to protect your loan) that expires the next day? So this can't be confused into a put/call parity discussion again (the very reason why I framed it as 1 day before expiry). And 1 day of margin interest isn't even worth discussing.

Or take two $18 strike call option owners (two different people). Person K owns 1 call option Person F owns 1 call option The company is going to pay a $1.08 regular dividend the day before the call options expire. Person K exercises the option and collects the dividend (using borrowed money). His dividend is 6% return on his equity. Person F does not exercise and misses out on the dividend. Who has 6% more money? :D

Let's say person A has $18 to his name, and person B has $18 to his name. Person A buys 1/2 of a share for $18 and earns 3% yield (assuming it were allowable to own 1/2 share) Person B buys 1 call option for $18 and earns no yield at all, even though he has an entire share of upside (twice the dividend loss) So if the economic loss is twice as much, what are you getting hung up on?

fyi: IB doesn't offer "Dollar for lot" if the options have an expiration date. So that program can't be used to close out the typical puts and calls that we are accustomed to dealing with. Here is the relevant snippet from my chat session with them today: Stan M: Sorry this won't work. IB does not extend the Special Position Liquidation program to options that have a definitive expiration date. Stan M: Additionally, IB does not offer cabinet trades.

I just know that his house sitter isn't famous for sitting houses, but that's what he says she does for him. Glad he is providing her with honest work.

Correct, based on that 3% dividend assumption on today's market price. People are expecting the stock to go up 40% (or at least Kyle Bass is). That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend. So the total cost of leverage would be greater than 10% a year. So it depends on the dividend. I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend. I think you're probably right about the potential downside risk (how ironic) to a really nice dividend being reinstated for the GM warrants. Most likely, I'll be switching to the common. Thank you for your posts on this subject of leverage. You can always wait until that dividend actually arrives -- the warrant decay isn't that big of a deal since you didn't pay much premium for the warrant. EDIT: But there again, why the $18 strike? Why not a short-term higher strike call? That way, if the price of GM does in fact fall hard, one could get in cheaper (below the strike). My favorite would still be the common+put.

There is actually a $3 strike BAC 2016 call option. Imagine how expensive the leverage would turn out to be if they were to pull out a 40-60 cent annual dividend. That call would turn out to be more expensive leverage than today's at-the-money strikes! Yet without all the downside protection.

Correct, based on that 3% dividend assumption on today's market price. People are expecting the stock to go up 40% (or at least Kyle Bass is). That would put the dividend at $1.72 (at 3% dividend payout yield level), which is 9.55%cost from the lost dividend. So the total cost of leverage would be greater than 10% a year. So it depends on the dividend. I'd personally prefer the portfolio margin approach here, because I see the rising interest rate to be a lesser risk than the rising dividend.

This is something I wrote to another board member offline today, explaining why I went back into the A warrants in my RothIRA in November when the cost of leverage had come down to 7.5%. I'm just throwing this out there because I earlier explained why it was a good time to sell them (back in March). So to be fair, I'm sharing my reasoning why I changed my position recently. Not that I know what I am doing -- keep in mind I am just a retail investor amateur! So I could easily be completely wrong. Plus I am also going back into the warrants for their other obvious advantage -- interest rate lockup. This is in my RothIRA account where I can't do portfolio margin. There is either call options, or there are warrants. Nothing else is available to me. So I use the dividend expectations of mine when I calculate what the true cost of leverage of the call options strategy would be. Sure... there is little premium to deep-in-the-money calls. But there is a big cost in terms of the missed dividend if I choose to purchase calls. So I weigh the cost of leverage when going with calls (inclusive of full cost of lost dividend) to the cost of leverage of buying the warrants today. The "A" warrants won that battle this time because their cost of leverage was only 7.5%. 7.5% was not that bad as long as it doesn't keep decaying. We have 5 years left. Most people will expect the dividend will be at least 60 cents in 2017, 2018, right? And perhaps earlier. So the cost of leverage of those years won't trend towards zero... they will trend towards the dividend expectations, in addition to the margin interest expectations, in addition to the cost of put expectations. The "A" warrant doesn't look bad at all anymore -- compared to my only other way of using leverage in an IRA, which is to purchase calls. There is the added benefit that if we get a crash and the stock winds up back at $12, the -annualized cost of leverage will rise once again as we get nearer to the strike (the skewness thing). So it ironically offers some downside protection as well (remember how the common appreciated faster than the warrant over the past 9 months?). Looked at another way... Suppose the stock is at $25 and the call premium is effectively zero (nobody wants to buy them because of the cost of the dividend loss). Could BAC "A" warrant premium also fall to a similar level? HELL NO! It would otherwise be all too easy to just purchase the warrant and write a deep-in-the-money call option. The person would be taking absolutely no market risk on the price of BAC common, and meanwhile would be enjoying the full benefit of the dividend strike adjustment. Therefore, the warrant premium will always be supported by the dividend expectations. This easy arbitrage I mentioned will ensure this. *Guaranteed. * Of course, I jest, I jest... there are no guarantees. Just a little colorful hyperbole. Clearly the market doesn't always behave the way I think it should.

You can only buy mutual funds in 529 plans. Did you know that Fairholme Funds offers Coverdell ESA (Education Savings Accounts)? My kids each have some of their college savings funds managed by Bruce Berkowitz via those accounts.

We are thinking the same way, I just wasn't careful in how I described my example. yes, two shares of upside. two dividends missed. twice we "borrowed" $18. Thus, 1 missed dividend per $18 borrowed. Therefore, the missed dividend of 1.08 (per call) is 6% of the "borrowed" amount of $18 per call. I get that 1.08 / 18 is 6%. I just don't understand why we would think we should get the 1.08 in the first place. If we had bought $18 of shares, we would have got a 3% yield, or .54. If my choice was to buy the common unlevered or to buy the call, or some combination, nothing was going to give me a 6% yield, so why would I be missing that unattainable 6%? Example 1: Using portfolio margin Let's say I only have $18 to my name and I buy 1 share of common stock for $36 using $18 of money borrowed on margin. I get dividend yield both on $18 of my own capital tied up and on $18 of the borrowed money Example 2: Using calls I don't get a damn bit of dividend on my own $18 of equity, neither do I get a dividend on the $18 worth of synthetically "borrowed" money. In Example 2, I not only miss out on dividend yield from the $18 borrowed, but I also miss out on the dividend yield from the $18 of my own equity that I contributed. So that's why it's 6% cost and not 3% cost. Because you synthetically borrowed only 1/2 the price of the stock, but you gave up the dividend on the entire thing! Your own money got no yield. Normally, if you invest your own $18 into the stock you get a 3% yield. But that vanishes when you add $18 of "borrowed" money to the deal. So you multiply it by 2, and thus it becomes a 6% cost of having added $18 of leverage. Yup. But if the writer of the call borrowed money as in example #1 and used it to write a covered call, that double dividend would influence him to charge less for writing that call, especially compared to writing a put where posting a compensating balance would earn almost nothing --- thus leading to demanding a higher price for writing an equivalent put. I think it's likely just the wording but I don't understand what you are getting at. So if I repeat what you are trying to say using different phrasing, it's an accident. I think normally if somebody is trying to earn a leveraged dividend yield (buying extra shares on margin) they would want to hedge with a put and pay for the put by writing a call. That way they would get the leveraged dividend with no price risk to the common. This would be such a good trade that it would be chased by traders until it skewed the put/call out of parity to the point where the trade no longer had any leveraged benefit for the given interest rate. Is that what you are effectively saying?

Here is an easier phrasing: You are prepaying all of this interest, long before it is due, which is effectively an interest-free loan to the very person you are borrowing it from. Thus, you aren't really borrowing as much as you think. Therefore, you have to figure out how much you are really borrowing first, before then calculating what interest rate you are really paying. And that is an easy calculation. Given: BAC stock price $15.60 BAC "A" warrant price $6.54 Strike price $13.30 x= cost of leverage interest rate $15.60 - $6.54 = $9.06 Now you need merely solve the following equation for 'x': $9.06 * 1.x^5 = $13.30. I'm using 5 years in the calculation to keep it simple, even though we're not exactly 5 years from expiry.

Think of an individual with a steady job but not a penny to his name, getting a zero-money-down 5 year term $20,000 car loan that is interest-only and a balloon payment is due at the end of 5 years. I know, I know, suspend your disbelief for a moment. I believe it is a better loan for this consumer to pay the interest monthly as it accrues. That's the whole reason why they wanted a loan in the first place -- they have no immediate cash and need to borrow. They can't prepay it. Instead, suppose they have to prepay all of the interest. Okay, that's $5,000 in future interest that's due immediately before they can drive the car off of the lot. But they don't have $5,000. So they have to borrow it. And you aren't including the cost of borrowing it in your calculation. Borrowing it costs more money! And that's an easy way to see that the loan is more expensive than your (and Greenblatt's) calculation suggests). Back to our options & warrants... you effectively have to "borrow" more because you have less equity with which to purchase the stock after pre-paying all of that interest upfront. Or looked at differently, you are giving the lender an interest-free loan (by prepaying interest long before it's due) and carrying on as if handing out interest-free loans has no economic cost. So anyways, I think Greenblatt is incorrect. The calculation that I make really isn't that hard, and it's accurate at the same time.

I didn't engage because it was getting off track. What interest rate did you use? There is $18 being "borrowed" in the case of the call, but not in the case of the put. Did you omit that expense from the call? You're right, I'm more interested in the other half of the discussion. I was just thinking that since calls don't get the dividend on one side and the puts + stock do, then the puts would necessarily be more expensive than the calls. It would depend on the bond yield, so that's probably why the dividend yield didn't matter that much. Still, though, if one can get double the dividend by margining + puts, it would seem like the puts price should reflect that difference in possibility. I'll focus back on the other conversation though. In November I bought BAC A warrants again in our RothIRA accounts. My thinking was around the 7.5% cost of leverage (waaaayyyyy cheaper than in March), and the prospects for the dividend coming soon, and the relative convenience of "one and done" trading for the next 5 years. Having a Roth account is a trading liability because I run the risk of losing my taxable losses if they wash into a Roth trade - so I am very careful about managing that risk. Anyways, that wash period is over soon (then I can take the taxable loss on my expiring puts). Let's say BAC pays a 60 cent dividend (in 2015 or 2016) -- that would be 4.5% cost of leverage justification in those A warrants. Then let's say 2% cost for the put and 1% cost for the margin loan. That adds up to the cost of leverage in the A warrants at 7.5% rate. So they look like they are attractively price, IMO. I aggressively moved into them in November.

I didn't engage because it was getting off track. What interest rate did you use? There is $18 being "borrowed" in the case of the call, but not in the case of the put. Did you omit that expense from the call?