ERICOPOLY

So lets take the LEAPS completely out of the discussion and focus instead on the psychological point I just mentioned.. How interested are you guys in leveraging up on fully valued banks using 6 year warrants that are deep-in-the-money? Is that 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? Both are largely the same when the huge premium is big enough to wipe out the rise to IV!

Regarding psychology... You got too caught up in the timeframe of the warrant to recognize that you were unconsciously choosing to leverage up on the stock movements that occur after the return to intrinsic value. Once I recognized that the warrant was effectively going to do just that, it became completely disinteresting to me. What was interesting to me was finding a way to leverage the return to fair value. Even though it carried the risk of the price going higher when rolling, it offered so many things in return.

In short, the warrants were a method of getting no leverage early on when the stock swings to $20, and then after that you'd get your leveraged return mostly from a deep-in-the-money option that is decaying to expiry on a mostly fully valued stock. And the much heralded dividend feature would put your dividends into the mostly fully valued stock. But guys... Are you the kind of people that normally wait to put on your leverage until most of the return to full value? Do you normally sell when the margin of safety gets thin, or is that when you like to start adding your leverage? You don't think I realize that smart people like you can allow their fears to drive them to make silly plans? You guys can't tell me that you didn't know that option premiums are always thin for in-the-money options. You knew that to be true even for the warrants because you witnessed the warrant premium at only $2 in Dec 2011 when the stock was at $5 and implied volatility was very high. You could see that the delta was $3.65 (compared to when this thread began when it was $5.65 and at-the-money in a lower volatility environment) and that the same thing was going to happen to the premium pricing if the stock rose near $20. So it was not going to begin to offer you leveraged returns until it got well into the money. But you guys tend to want to be in undervalued stocks and participate in the swing to fair value. You never get excited about the opportunities to be leveraged in stocks without much margin of safety. Because of the very large amount of premium to be eroded, the warrant would need to be greatly in the money before it could get much advantage over straight common. So that's primarily why I called you guys silly. Your psychology was driving you to behave in a manner akin to leveraging a stock without much margin of safety. But you didn't see it that way because your fears over holding a short term option were driving your thinking. I specifically made this point well before the shares took off -- this isn't hindsight. I even mentioned that towards the end of the warrants term you'd be too scared to see it through to the end for the very reason that you guys keep mentioning.

Of course volatility is used in option pricing. I've never said otherwise. What I've said is that the option premium gets inflated when the warrant is near the money, and decimated as the option goes out of the money. The option premium was only $2 during high volatility in December 2011! That happened because it was far out of money, not because volatility dropped. Rather, that happened when volatility soared. Later, in 2013, the premium was $5.65 despite a much lower implied volatility. That was a huge spike in premium despite lower volatility (compared to Dec 2011). The risk isn't higher implied volatility. It's the combination with a flat-lined stock price.

I read that a lot of drilling rigs from the Bakken were brought to California in this drought -- demand from farmers needing deeper wells after the groundwater levels dropped. Whoever owns these rigs doesn't want this rain, what with the oil bust and all. Should this pattern hold, reservoirs might be topped up by May.

I wonder if something like the US nat gas would happen to oil. It sounds much less likely though, because oil is a global product but US nat gas is restricted for export. Good news for GM I suppose. People will all want big trucks again after oil goes down like that for two years. I think people will want better cars... So that means more efficient cars like Tsla. It's good if our enviroment is cleaner - not having to breathe poor air quality - we are so spoiled on the west coast... places like China and many parts of Asia are so polluted. I wonder if cheap oil prices is a form of deflation - now that things will be cheaper. It's about as deflationary as cutting both consumer and business taxes at the same time.

Hmm...

I wonder if something like the US nat gas would happen to oil. It sounds much less likely though, because oil is a global product but US nat gas is restricted for export. Good news for GM I suppose. People will all want big trucks again after oil goes down like that for two years. Stupid is as stupid does. Funny you say that! My mother always said that too.

I wonder if something like the US nat gas would happen to oil. It sounds much less likely though, because oil is a global product but US nat gas is restricted for export. Good news for GM I suppose. People will all want big trucks again after oil goes down like that for two years.

From 10,000 feet, I just see an oscillating pattern of oil driven by oversupply and undersupply. I see people justifying high prices when they are high, and low prices when they are low. I know that high prices create oversupply and that leads to low prices, and then I see that low prices leads to undersupply that leads to high prices. Low prices frees up money that boosts the economy, and then the economy adjusts and later gets shocked by the inevitable dawn of higher prices. I buy PWE in a small amount because it will swing a lot on higher prices which is a hedge on the rest of what I own that doesn't respond well to oil price shocks. I fear I am too early but a 70+% decline already seems impressive. It could become a 90+% decline but I don't know when the Saudi's will cut production. I have no confidence to add to my position yet that started at around 2% of net worth and is now 1.5%. I need more time to settle in, get anchored, and make up a narrative that I believe in. Otherwise, I'll probably just sell some common to buy calls after it makes large further drops. But not yet.

Gold shot up more in the years before 2008 than the years after. It more than doubled from early 2005 to early 2008, that's just three years. Then a whole lot of QE debasement happened since, but it's only up 32% cumulative to date since the start of 2008 and that's been 7 years! I am not saying you are wrong though. I'm just checking to see what impact QE had on gold so far.

Just to be clear, I don't think the puts can make all that much money because the central banks are there putting a floor under the equity markets, but I think this may be the start of a little downdraft until they come in. This is why I actually like precious metals better than the puts at this stage. Of course take all of these timing remarks with a grain of salt / speculation on my part - nobody really knows what the future holds. They were (in their dreams) putting a floor under equity markets in 2008 but markets still got crushed. Gold went down too (up until end of Sept), as did all those miners. This ain't 2008 Eric, not even close. In 2008 they were caught offside in the downdraft without necessarily being mentally or operationally prepared to bail-out the whole system with unconventional methods. Now, they are willing to print print print, the unconventional has become conventional. Its a whole new ballgame - its debasement. So how can we short that? We can't do it with straight puts on the index, we need to be long precious metals at the same time. What you really want to short is stocks vs gold, not stocks vs currency that is being debased. QE was going on for most of the past 5 years. That's debasement right? However GLD (the ETF) increased in price from $109 then to $118 today. It was a volatile trip, but the end result was disappointment. That's less than CPI or roughly the same.

In fact... The warrant premium is HIGHER today in this LOW volatility environment... compared to late 2011 in a VERY HIGH volatility environment. The premium TODAY is $2.77 The premium THEN was $2 Yet, at the same time... THREE YEARS of time value have been destroyed. It was a 7 year warrant in late 2011 and now it's just 4 years left. It's about time now for you to reassert your opinion that it was all due to falling volatility. ::)

Warrants were decimated in 2011 when the stock dropped to $5. The warrants were just $2 at the time. Despite the fact that volatility in late 2011 was twice as high as it was in 2013. Can't you now see that skewness trumps everything! Even when volatility soared in 2011, the warrant premium still got crushed.

And yes, predictable and expected -- options that are deep-in-the-money have almost no premium (that's skewness). ni-co will now reassert the largely irrelevant claim that I could not have predicted the drop in volatility. A red herring.

Precisely!

No... Any large moves in the stock price trumps the impact of implied volatility risk. You should be an expert on skewness by now :) My point all along is that my "scary" scenario is that BAC remains flatlined near $12 stock price for the entire first 4 year period. That's the trading range where I'm exposed to volatility spikes that could increase my costs higher than 13% on successive rolls. But I actually get paid for that risk when the stock jumps 50% over the near term. You didn't get paid. Like you said earlier, you don't get something for nothing. By giving up your first 50% gain, in exchange you saved a few pennies (possibly) by locking in your leverage at 13% vs risking it going higher. You take on more tail risk at the same time -- BAC goes to zero in first 2 years and you lose all the premiums paid for years 3,4,5,6. Or BAC goes to $20 and you similarly lose a ton of premiums for years 3,4,5,6 (due to skewness). It's sort of funny that a good outcome for the stock kills your premium, but it is the way the world works. And yes, predictable and expected -- options that are deep-in-the-money have almost no premium (that's skewness). Now let's step back a moment and reflect shall we on the wisdom of risking 32% from skewness if the stock rises 50% over the first two years.... the very near term where we were all expecting earnings to go positive, legal clouds to diminish, bad loans to runoff, "newBAC", LAS expense runoff.... And now you only have two years left for this stock to make hay for you... after that you'll be terrified because it will effectively only be a 2-yr LEAP and your strike can't be increased like mine can. So you risk losing everything, but I don't because I'm moving up my strikes when I roll. So it's my strategy that will outlast a crash that comes at the end of the 6 yr window -- you are carrying tail risk. Even WFC dropped from $30 to $8 in 2009. Six years earlier, at the start of 2003, nobody could predict that crisis.

Next we'll hear you tell us that nobody can predict that a soaring stock price would be accompanied by falling volatility. Oh wait... darn... you already did! My bad.

LOL!!! I predicted that skewness would destroy the option premium and erase most of the gains as the stock headed towards $20. Of course that's predictable! That's how skewness works. So, given your comment above... I'm pretty sure at this point you think that skewness is either 1. BAC's dividend policy 2. Implied volatility HINT: neither! ;D You would need either a massive hike in dividend policy or a HUGE spike in volatility to overcome this. 1) huge dividend hike has to be approved by the Fed so the risk was ZERO over the first year 2) volatility falls when uncertainty drops, and falling uncertainty lifts stock prices So it was most likely that you'd get smacked by both skewness and declining volatility at the same time if uncertainty around BAC diminished.

So listen to Warren! He tells us that long term puts (like the ones in these warrants) that are priced in a high volatility environment are inflated in value because they "overstate the liability" of the writer of the option.

I added bold red to the Warren quote above. Warren wrote those puts, he didn't buy them. He is telling his shareholders not to sweat the inflated option premium because it overstates the liability. You chose to ignore his warning when you bought a similarly overstated liability represented by the put embedded in the BAC warrant! On your books it is an overstated asset (you are the buyer), and on Warren's books it is an overstated liability (he is the writer). Yet you claim that Buffett's comments encouraged you to buy them!!! The following is what you wrote: You completely misunderstood his message. He told you long dated puts (with high volatility priced in) aren't worth their premiums, not the other way around!!!

So imagine if the stock were at $24 today with a huge $1 dividend... US taxpayers holding the warrant would have to throw extra cash into the deal to pay the taxes. Those holding the leveraged common could just use a portion of the cash dividend. Why would you want the dividend invested into a fully-valued stock anyhow? Kind of a problem with the warrants once we get near full value.

US taxpayers pay dividend taxes on the warrant even though it is a non-cash dividend. There is no double-tax because they add the dividend to the warrant cost basis.

Pretty low -- it would just be the delta between the two. So if he could have bought them for 10% but is instead getting 5%, then his cost of leverage is the opportunity cost. So cost of leverage is 5% for Warren's warrants. No skewness risk to erase early gains because this is different from buying a premium that swings in value.

On day one, he was holding the preferred for a loss. That loss was his "cost" for the warrants. However the market erased the loss once uncertainty was lifted and the preferred yields settled back down. His cost has essentially been refunded. nico's premium is lost forever. The market isn't going to gift it back to him.