ERICOPOLY

Wow this is amazing find. Is Mr Market really so dumb to offer this opportunity? Or is there more to it? Of course we will only know for sure who is so dumb with hindsight.

Doing that raises your downside risk because the implicit put is at a lower strike. It leverages your downside (slightly). Had I used those $10 calls in my arguments from the beginning, I would have been called out by the many sharp people on this board.

Housing in the US (median home prices) never once declined during the 60s/70s/80s. There were years when they lagged inflation. A typical homeowner who started with 20% down payment before rates spiked, I believe, had real gains in home equity nearly every year if not every year (levered 5:1 initially against the nominal rate of appreciation). My father remembers those years fondly because he bought his home in 1970 and inflation eviscerated the real cost of his mortgage. He was an engineer with a secure job -- wages climbed with inflation, mortgage payments did not. His largest annual expense rapidly declined in real dollar terms. Inflation improved his purchasing power. We enjoyed more luxuries because of it. Inflation gave our family positive operating leverage.

I can't remember who it was, but some famous RE guy was asked why he did so well in the 70s and/or 80s. He said it's hard to do poorly when you borrowed at 5% and then had a period of double digit inflation. Wouldn't that be the best time to invest for real estate? If you think inflation is coming shouldn't you borrow now at low single digits and buy an inflationary resistant asset like RE? I guess what you are saying make sense if we are buying in all cash. He was just thinking of the price. However, people who are renting face higher rents every year. The imputed rent for the heavily mortgaged homeowner is fixed (nearly, property tax increases, but the interest costs are fixed). A landlord, unless there are rent controls, gains positive operating leverage from inflation if he is heavily leveraged at a fixed rate.

Anyways, Berkshire is a certainty. BAC is an uncertainty. Even if you write in-the-money puts on Berkshire, it's a certainty that even if you get assigned the shares you'll be made whole if you patiently hold the stock long enough. That's a way that I suppose you could have gone 100% into BAC in December 2011 when it was at $5. You would simply have hedged it at-the-money with proceeds from writing in-the-money Berkshire puts. And today you would have been made whole even if BAC had gone to zero. You would merely have lost the opportunity cost of missing out on the Berkshire gain (your gain after getting assigned on Berkshire mostly went to paying off the cost of the expensive BAC put).

You can't prevent stocks from going lower, unless you are Bernanke. :P All I'm saying is make sure you are swapping insurance on $1 of stock for insurance on $1 of another stock. Let's say you want to purchase puts at-the-money on BAC, but you want to finance it with puts on Berkshire. You'll need to write in-the-money puts on Berkshire because that's the only way $1 of Berkshire risk is going to fully pay for $1 of BAC risk. But that's fine if you think Berkshire is backed by that "Buffett put" that others talked about and can only increase significantly value from here over the term of the put. The market isn't stupid most of the time -- you'll have to either lose a bit of money on financing the BAC puts or you'll have to accept the consequences of writing in-the-money puts on stocks that the market thinks are lower risk.

I don't use a website. I'm not sure it would help anyway, as you really need to be careful what shares you might get assigned if puts are exercised. So better just to stick to what you think is already undervalued (usually those puts are likely high premium due to the uncertainty). Maybe you think BAC has a nearer-term catalyst but the others have solid downside (but no catalyst). That might be a reason to go "all in" on BAC upside but swap it's downside for that of others.

I can purchase Nov 2013 puts on BAC (to ensure they expire this year) and finance them with Jan 2014 puts on other things (maybe SHLD). Later, when the Dec 2013 puts on BAC come out, I'll roll the Nov puts into the Dec puts. I'm pretty sure they'll issue the series that ends on Dec 31st, like they always do. That way, I can then close out the SHLD puts at market open on the first trading day of 2014. I (expect to) take the losses on the BAC puts in 2013, and the gains on the SHLD puts in 2014. Given the large amount of short-term capital gains I just booked from selling my BAC warrants, I can use a good tax write-off. The SHLD puts I write will be short-term gains as well, but I push them out a year (okay, a couple of days) where my tax bracket might be lower. And if I do this every year, I might never pay those taxes. EDIT: Yes, there is a risk of crash at market open in 2014. So, a bit more than a month before the BAC puts expire, I purchase a new series of them. Then after the SHLD puts expire I write more (to finance the BAC puts purchased in November). That way there is a lock protecting the window of time over the New Year holiday. Question: Is it necessary to purchase the 2014 BAC puts a full month before those 2013 BAC puts expire? I'm doing it that way because I presume otherwise there would be a wash sale rule problem with not using those losses in 2013.

Fascinating discussion. I understand that you're essentially converting your downside in BAC into downside in a diversified position (say an index) , but what if the market does go down substantially, wouldn't the short index put be exposed? If I am not mistaken, the long put hedges the underlying, but you end up with a large unhedged long position on the index? You still have 100% downside risk. It's just not concentrated in 1 name anymore. And be careful writing puts -- make sure that you aren't leveraged in the situation where 100% of your puts get assigned.

This is a brilliant example. Just curious, in the above example do you pick out SHLD randomly? My guess is no.. I think you found it because it has a relatively high time value. If so, I wonder if you use a particular website to filter these high time value names. I have been following the entire thread. Thanks for the great knowledge dispensed. An elegant and rational way to think about options and leverage. SHLD has been heavily shorted for years (it's expensive to borrow the shares for shorting it, so the shorts use the puts in the options market). This puts a lot of pressure on the price of SHLD puts. I know many people on the board "can't get comfortable with BAC" because it's a black box they say, and some of them like SHLD perhaps, so I wanted to point out that you can take the downside of SHLD after a 50% decline and swap it for a 20% decline risk of BAC. So being a pussy isn't an excuse. You don't have to take the risk of BAC in order to take it's upside. Of course, you have to be able to stomach the downside of SHLD.

And swapping risk is what these things are designed to be used for in the first place. So I'm hardly stating anything original here.

Some people diversify their portfolio to reduce risk. But they miss out on concentrated upside from what they know is their single best idea. Remember the comments from people about how it "takes guts" to focus all the money into a single stock? Well, that's total bullshit, actually. It assumes the downside risk is also 100%. But it doesn't have to be. You can have 100% upside in one name, but you can have 100 different names where each one represents 1% of downside. This is like a Frankenfund. Concentrated upside, diversified downside.

Example: The $10 BAC puts (2015) are bid at nearly 10% of strike. The $25 SHLD puts (2015) are bid at nearly 10% of strike. So at those strikes they both cost the same for insuring a dollar of risk. So I can swap $10 BAC downside risk for $25 SHLD downside risk. So, worst case, I might get put SHLD after a 50% decline from it's current price. But I get protection from a 20% decline in BAC. EDIT: I guess it's obvious, but I meant to say the worst I can suffer from BAC is a 20% decline. It no longer matter how far it drops beyond that point.

BTW..If my questions are becoming an annoyance to you just let me know:) But I want to thank you again.....I know you say you got a lot out of this discussion.....but I don't think that compares to what I have gained...you explanations and patience have been nothing short of incredible. Hats off to you! I benefit because if I tell you something incorrect, and another poster spots it, I learn too.

1.5x leverage means if I can only afford 10 shares of BAC with my cash, I buy 15 shares. The extra 5 shares is hedged at-the-money, so the "loan" is non-recourse. The "loan" might be money synthetically borrowed via a LEAPS call contract.

Learning about portfolio margin helps me enormously for managing my taxable account. Now I can be 100% BAC common stock on the upside but 10% on the downside. Under Reg-T, this would blow up my margin limits in a crash and so I couldn't do it to my full satisfaction. So if I'd known about portfolio margin in the past, things would have been a lot less worrisome for me. Here is what you do. 1) Go put 100% of your portfolio in BAC common stock. 2) Purchase at-the-money puts to protect 90% of the BAC position 3) Write puts on other securities such that you now have 90% downside in those other names Reg-T rules treated this as 1.9x downside I believe, even though it's really only 1x downside. The cash from writing puts on a diversified basket of names finances the puts that protect the concentrated BAC position.

Hyten...I believe you are correct.....that is how the gains are locked in. That isn't exactly my plan. Okay, suppose you start out with 1.5x leverage -- you initially hedge the 0.5x. Later the stock doubles and the account is now leveraged 1.25x. When I roll, I plan to hedge only .25x. So I'm only interested in hedging the amount "borrowed". Over time, the amount "borrowed" becomes a smaller percentage of the pie -- but nonetheless, I always hedge the absolute dollar amount initially "borrowed" at ever roll. As long as the stock is rising, this means fewer and fewer contracts on successive rolls.

I got a lot out of this discussion. First, it was nice to have a sounding board and many people try to tear up my logic. That helped me clarify my reasoning. Second, I didn't even know about portfolio margin! That solves some problems for me :D Upgraded my IB account a few minutes ago -- pending approval. Next time I won't need to be so darned paranoid about a flash crash. There is no actual "call" at IB with a margin call -- they just go ahead and liquidate you. That makes the Reg-T margin account a bit of a potential terror.

I understand so little about business, I usually don't feel comfortable investing in the majority of ideas presented on this board. Literally, I just get so confused trying to figure them out that it's hopeless. I guess that explains the concentration. Finally I can understand something well and that's such a rare experience for me that I get carried away with the position sizing.

Despite the short-term taxes, I think the total tax bill from that sale will be recovered by not losing warrant premium when the stock is at $20 in two years. So I look at that as being nearly tax-free -- I was going to lose it anyhow. Of course, that's what I think is likely, not certain. Plus, now as the stock advances I can roll to higher at-the-money strikes. So it will be a safer strategy as well, locking in the gains from leverage as they come (during each annual roll).

This isn't for me, but if you really want to bet on inflation with both TIPS adjustments and GLD as a combined tailwind: Say you start off with $10,000 in the account -- account is 100% in cash. 1) You write a deep-in-the-money GLD put, then purchase a GLD call with the same strike. You now have a $10,000 notional long GLD position Thus, you have not used any cash yet. 2) Use $10,000 of cash to purchase TIPS. When hyperinflation hits, you get the CPI adjustments from the TIPS as will as the skyrocketing price of gold. You really high margin allowance for TIPS, given that they are a government security.

I find it amazing that a person can put their last penny into their 20% down payment, walk out with a 30 yr mortgage based on their income, and be 65 years old. Are they going to work until they are 95? I work in the mortgage business in the US and feel it best to clean up some misconceptions. Eric's scenario is not wholly correct. Yes, someone who is 65 can get a 30 year loan provided the income/credit profile is acceptable. The irony is that a lender cannot use common sense that the borrower will almost certainly NOT be earning the same income 15 years hence, let alone 30, as that would be age discrimination. The part I will take issue with is that they would be hard pressed to get this loan using their last penny as reserves (assets AFTER the loan closes) are required. Now, if this same person wanted to only put down 10% thereby holding the remaining 10% in reserves, and they were OK with paying for mortgage insurance, then they would be golden. I appreciate being corrected -- if nobody does that for me I'll just remain ignorant. That's worse!

By the way, the "cost of leverage" has slipped under 12% annualized now for the warrants -- it was at 13% annualized when this discussion began. Regarding what BerkshireMystery said... I was on the fence due to tax issues, but then I went ahead and sold all of the class A warrants the next day after doing more analysis of the relative merits.

I believe they are objecting to my comparing the prices of two hookers. I'm considering their relative advantages and using price as a consideration. Their chief complaint seems to be that they're hookers. However, the title of this thread is effectively "hookers"... so why aren't they at home clutching their bibles anyway?

If you made a book or movie about my thought processes or trades, you would become the Salman Rushdie of this board and I can name the people (board member's here) who would be likely to pool their money together and put a hit on your head. One of them in particular, I suspect, would be the one to issue the fatwa. ;D