ERICOPOLY

In summary, I care about the extrinsic cost of the option when I roll it. So large stock movements (up or down) are my friend.

Debatable. I start with a $12 put (at-the-money) and a $12 stock price. The intrinsic value of that put increases as it goes deep in the money. However, the extrinsic value of that $12 put plunges. So let's say it started off as a 2014 put. Stock drops from $12 to $7. While the stock is at $7, I roll my $12 strike 2014 put into a $12 strike 2015 or 2016 put. You understand why the extrinsic value of deep-out-of-the-money and deep-in-the-money options are cheap. It's the Rumplestiltskin first-born-child analogy. The option's extrinsic value plunges because it becomes priced like the straw. The cost of spinning that straw into gold is the first born child (the intrinsic option value). This force driving extrinsic value is what I've been calling "skewness" and it is far more dominating than volatility. That's why the entire time I've been saying the flatlined stock price is what worries me. If it remains flatlined, then changes in implied volatility is the dominant force. But if the stock price itself is very volatile at any point in time, I can use that to roll the option along cheaply.

Eric, Watching you and ni-co go at it in the other thread, I was going to interject, and express the above trade-off. The way you have expressed the trade-off demonstrates your pristine clarity of thought on this particular subject. Its absolutely the trade-off being discussed. And, yes, its stupid to choose one option and smart to choose the other. Also your analogy to Buffet's bet is bang on. He sold the same put you are arguing people should not buy. Cheers. BTW, this is Original Mungerville (It looks like I found my old moniker somehow using a computer in the house I never use? Anyway) Thanks. It's nice for people who understand my point to speak up. Otherwise the people who don't get it think they are in a majority because we only see their posts (and that fuels their belief). And that only attracts more detractors via social proof.

The absolute size of the first-born-child is what primarily drives the option premium so low that it becomes priced like straw. I think this Rumplestiltskin analogy will be familiar enough for people to understand. That's skewness. The bigger the value of the first-born-child, the more cheap the straw becomes. Once the child is extremely valuable, no amount of volatility spike is going to make much difference to the price of the straw versus where it was priced initially at-the-money. Small changes, but not much. If 1 penny doubles to 2 pennies, so what!

And for very, very long term warrants, what is deep-in-the-money today is (somewhat) effectively at-the-money many years down the road. By this I mean that a long passage of time lifts the trading range of a good business. Just like a $14 tangible book value today is more like a $30 tangible book in forward looking (10 years) terms. So I'm okay with going deep-in-the-money on a much longer term warrant. The very long period of time reduces the probability of the first-born-child payment. Yet at the same time the put buffers you against near term crashes down to near strike. A bit like discounting a future value to the present (similar concept).

Rumpelstiltskin. Think about the potential cost of the "first born son" when looking at cost of leverage comparing at-the-money puts compared to out-of-the-money puts. The deep-in-the-money calls have out-of-the-money puts. These puts are priced like straw, and the price of turning the straw into gold is that you have to give up your first born child (the intrinsic option value that you are risking). It's very, very, very different to compare the cost of in-the-money leaps leverage to at-the-money. It's comparing (less) recourse leverage to non-recourse leverage. Or comparing high-deductible insurance to no-deductible insurance. Actually, I think you know all of this. I just worry that people will somehow think that's how I look at cost of leverage since I initially raised the topic.

A reminder that when this thread began, the deep-in-the-money WFC warrant had a cost of leverage of roughly 5%. That was 5% in the VIX environment of 2013. Not today's VIX. One of my arguments then was that once BAC's cloud of uncertainty cleared and stock rose it would be difficult to see why BAC's warrant would be priced any different. This I suppose is one of the reasons why I get so impatient when people try to blame it all on the lower VIX of today. The 5% warrant cost was 2013 pricing!

For shorter dated, I prefer to just go at-the-money so it's non-recourse if it goes south. I don't find it worthwhile to go deeper into the money on shorter dated options to save pennies of leverage costs. For very long dated warrants, going deeper in the money is a lot safer because it trades closer to the unleveraged common portfolio when stock price declines toward strike. Then, at that time after the decline, dump the warrant and buy the at-the-money LEAP again (assuming the warrant is priced once again like last time). Then if the stock soars, switch back to the warrant. Repeat again and again if possible.

My main goal in life when I began this thread was to step out from in front of the freight train that was about to clobber the BAC warrants if the stock soared. I wanted to leverage that outcome and outperform the common. That risk doesn't exist anymore today in the deep-in-the-money warrant and so I prefer the warrant for it's downside (it's inexpensive embedded put will soar in a crash) and fixed interest rates and fixed volatility. To my amusement, when I decided to get out of the way of the freight train, I couldn't believe that the at-the-money options were priced as they were relative to the warrants. A great way to pick up non-recourse leverage relatively cheaply compared to the favorable upside in the stock. I didn't even have to pay a premium for the shorter-dated LEAPS, something I was stunned at.

My reasoning there is that if the stock goes into reverse, the warrant's premium will soar as it approaches it's strike price. Therefore, it puts on the brakes. You'd probably suffer much like the un-leveraged common even though your upside is leveraged. So the reverse of what just happened to our BAC warrants.

Wouldn't it be better off to just buy the deep ITM option in the first place, in terms of minimizing premium paid? I guess the downside to that is you need more capital for the same exposure. As long as it's a long term warrant, yes.

Yep, somebody (me) says something (risk from volatility when rolling if stock remains roughly flat) Somebody else then says I glossed over it I say it again They reiterate their claim I say it again Somebody new pops up and says I don't understand that very same thing I say it again They reiterate their claim over and over and over again. Then a new one arrives. Whack a mole.

Depends, as always, on whether another person is going to claim that it's not predictable for an at-the-money option premium to all but disappear as it goes deep into the money. As long as we've exhausted the list of posters willing to make that claim, we should be good.

I know the snow is needed to keep from overfilling the reservoirs (and having the excess flow to the ocean). But they are so low that it's all going into the reservoirs (not over a spillway and out to sea). After these storms, those reservoirs will still be under their average levels for this time of year. And as mentioned in this article, these reservoirs are important for irrigating farmland. The past year farmers were hitting the groundwater harder because the surface water wasn't available to them: http://www.mercurynews.com/science/ci_27120528/california-drought-winter-storms-finally-starting-boost-storage The state's two largest reservoirs, Shasta Lake near Redding, and Lake Oroville in Butte County, are projected to take in 510,000 acre-feet of water in storm runoff by Tuesday, with 370,000 going to Shasta and 140,000 flowing into Oroville, according to the state Department of Water Resources. That's a staggering amount of water -- 166 billion gallons from a single storm, enough water for 2.5 million Californians for a year. It would fill half a million football fields one-foot deep -- all captured by the reservoirs that form the linchpin of the federal and state water systems that serve millions of California residents from San Jose to San Diego and irrigate vast expanses of Central Valley farmland.

My local water supply (Lake Cachuma) made the list at #2 most likely to dry up: http://www.accuweather.com/en/weather-news/world-lakes-drying-up/30646819

It think Buffett's point (and mine) is that on a long enough time horizon the odds of the stock not being substantially higher at the mid/end of the contract is extremely low. Those odds only get magnified if it was already deeply undervalued to begin with. And so the warrant will be overpriced if you put any significant sum into the valuation of it's (mostly useless) put.

ni-co asked me about the dividends... The dividend assumptions were priced into the warrant upfront. So you paid for the dividend upfront. Nothing is for free. But your prepaid dividends would be worth twice as much if reinvested at $12 versus at $24. So your prepaid dividend premium craters in value as the stock soars, versus if you had just invested them directly into the stock back when it was at $12. That's also worth thinking about. It's not a bad idea to invest your dividends while the stock is deeply depressed, versus later on after it doubles or more. That's a decent argument for avoiding salesmen who offer you dividend protection premiums on synthetically leveraged instruments for deeply undervalued stocks. The premiums should get clobbered MTM by a large swing up in the stock price. Well, I think it's obvious that the dividend protection has more value at lower stock prices than at higher stock prices. Does anyone disagree with that? The premium of prepaid estimated dividends is only worth half as much at $24 versus at $12. No? So you should ask for a discount right? Or is that "path dependence" to ask for a discount?

Keep this in your head while you are reading this thread again from the beginning... Each time I get accused (by Hielko, Sunrider, ni-co, and more) of making "path dependent" and "volatility assumptions" and so therefore I cannot call the warrants "overvalued". THEY KEEP QUIET when Buffett makes the same claim about his long term put liability being overpriced due to how Black-Scholes uses short term volatility in the pricing of long term options. Guys, go challenge Buffett at the annual meeting -- tell him he can't call it "mispriced" without making path dependent stock price assumptions and similar regarding future volatility. Buffett doesn't make that argument about short term options. Only long term ones, and if you probe him I'm sure you'll get an answer that to you looks like "path dependence and assumptions about future volatility". Then you guys can all tell him that he's wrong and you are right -- and how you've all been trying to tell him if only he would listen. And then add that hoards of knowledgeable people who also know as much as you are just being silent yet don't agree with me/him.

Buffett wrote long term S&P500 puts. Then in the 2009 Berkshire Hathaway annual report he wrote that the size of the liability was being greatly overstated by how Black-Scholes model prices short term volatility risk into a very long term option. In other words, he thought that whoever owned that put held an OVERPRICED asset. And a put just like that one lives within these warrants. The effect is most pronounced when at-the-money.

The at-the-money long duration warrant with the large premium effectively trades margin of safety in the stock for a margin of safety in how the leverage is financed. You are left with a margin of safety in your financing of the leverage. In exchange you are leveraging into a stock that has no margin of safety. That's the tradeoff.

So is it unfair to call it stupid? Waiting until it rises most if not all the way to IV and then leveraging up on it seems like a dumb strategy. I'm sorry if that hurts your feelings.

Let me express these at-the-money (ATM) warrants pictorially in terms of circles and radii. The longer duration ATM warrant have a circle with a larger radius. The shorter duration ATM warrants have a circle with a shorter radius. Now, draw a number line on a piece of paper and number it $0 to $40. Put the center of your circles all at $13.30. Okay, the point where you will start to gain leverage from the warrant lies towards the outer edge of each circle. So... if the warrants term is long enough, and that premium is correspondingly large enough... the outer edge of it's circle will lie at the price that represents intrinsic value! Even though the stock may presently be deeply discounted you are basically waiting to leverage up on it until it rises all the way to IV. That's how I think about it.

How interested are you guys in leveraging up on fully valued banks using 6 year warrants that are deep-in-the-money? Is leveraged GARP your style of investing? Is it a more attractive idea to leverage up on a deeply undervalued stock that is presently at-the-money with a huge warrant premium? Are you aware that at-the-money warrant premiums quickly disappear MTM as the stock climbs toward IV and if the premium was large enough to begin with it will not provide you with a leveraged return on the rise to IV? Thus your leveraged returns begin after the rise to IV, and therefore you are a closeted leveraged GARP investor. Did you realize that, or is this new information? (I started this thread because it is the more meaningful part of the BAC Leverage thread, but that thread is more dominated with a discussion about rolling shorter duration options as a way to leverage deep value when our only other choice is this "closeted leveraged GARP" ATM warrant strategy). So don't do any comments here about shorter duration options or it will derail the thread.

So if I had left it at just that, I think I might have grabbed your attention. But instead, I had to go and suggest a method of using shorter duration options to gain leverage on the rise to fair value... and that's all you heard apparently because it was an opportunity to fluff your feathers about prudence.

So you effectively gave up your value investing hat and became leveraged GARP investors. You got sucked into this unwittingly because all you were focused on is TIME. That's why I kept calling it dumb/silly/stupid to buy them. Value investors (if done right) make most of their gains as the discount in the stock price is lifted. That's precisely what you are not gaining leverage on here because that will get offset by MTM losses on the warrant premium as it goes deeper into the money.