ERICOPOLY

Warren knew the preferred was a below-market interest rate that would only be below market until the uncertainty lifted. That very same uncertainty lifting is what would drive the stock higher and cost him nothing from skewness (no warrant premium). Warren: Skyrocketing stock price costs him nothing because his preferred comes back to market level. So it becomes a "no cost" warrant You: Skyrocketing stock price destroys your warrant premium I think you struck a very bad deal compared to him.

The "package" was $5b invested into preferred stock yielding 5%. The warrants were a "gift with purchase". That's not any kind of warrant premium at risk of rapid and sudden decay from skewness. He did not take on ANY skewness risk.

I'm getting exhausted -- can it be your turn for once?

Yes, I think they issued his warrants in exchange for zero premium. Look it up instead of guessing. He bought preferred stock in exchange, and that doesn't swing in value from skewness. In fact, the value of preferred stock increases when uncertainty clears. However, that's irrelevant.

The higher you say your price target is, it only serves as further argument as to why you should have been more conservative with respect to the skewness risk. That's the very situation that led the warrant to become mis-priced, as you found out. Mis-pricing of these things for very undervalued stocks doesn't always work in your favor. It works in your favor when you enter the warrant at a time when the stock price and warrant strike are very askew from one another (like now and when the stock goes higher). But that wasn't the case when this thread began. It began when the warrant strike was nearly at-the-money. That's the precise time when the mis-pricing will NOT work in your favor. It works against you. And the longer the term, the more the mis-pricing of the warrant. And the greater the undervaluation of the stock, the greater the mis-pricing of the warrant. Those conditions coupled with the at-the-money valuation trapped you into paying way too much for the portion of the put at the tail end of the warrants life, when it will be just incredibly unlikely to still be at that level (due to the stock's initial extreme undervaluation). The only thing "wrong" with this trade was that it was a very undervalued stock and the warrant was priced at-the-money. The combination is a recipe for disappointment when the stock goes up 50% in the first year or two. The more and more you argue that it was worth $30 or $40, the more likely it is that the market will figure it out and the stock jumps 50% sooner rather than later... but you don't participate in the gain.

I guarantee my LEAPS put premiums will all decay to zero "blowing up". I also guarantee that you will lose 100% of your warrant premium "blowing up". 100% decline in value by expiry! Absolutely guaranteed. It's not a topic of interest. All that matters is what it will cost under various assumptions. Like... if it takes one year to hit $18, you would most likely realize a cost of roughly 50% for your leverage, completely wiping out your gains. And thus your strategy was always one that was of the variety to give up early gains in favor of hanging on to a deep-in-the-money stock later on that doesn't have much margin of safety left in it. Like I said at the beginning of the thread, I prefer to be leveraged in undervalued names and drop the leverage at full valuation. We are just different I guess.

The risk to the LEAPS is that I lose 13% annualized for 2 years (same as your average cost in the warrant). Now, if the stock plunges or soars, my premium will fall by a much smaller absolute dollar amount than your warrant premium. I have less on the table to lose from price swings. You had so much on the table that it completely wiped out your leveraged gains and then some. So how come you lost more premium if your approach is absolutely less risky genius?

Thanks! I'm learning, too. Eric, one question: Why do you think Warren Buffett was so stupid to demand in the money BAC calls with 10 years til expiration instead of simply insisting on cheaper preferreds? After all, he could have rolled standard LEAPs. I guess that any investment bank would gladly provide him with a sufficient amount. It must have been a time of really low volatility when he received those warrants… He didn't prepay a premium. He didn't take on any skewness risk. You did !!!!!!!!!!!!!!!!!! !!!!!!!!!!!!!!! !!!!!!!!!!!!!! Are you sure you are not just fucking around with me?

Yep, it was severely mis-priced because you paid at-the-money premiums for a very undervalued stock that wasn't terribly likely to stay that way. It locked you in to that pricing for a very long term despite it being a more likely than not temporary condition. The stock undervaluation tipped the scales of probability that a large move in skewness was in the cards. But you were getting no discount for this because the model knows nothing about equities undervaluation. And you were most greatly exposed to this because your warrants were at-the-money. I already have argued this!

Really? I said that my risk is (relative to just buying the warrant) higher than 13% cost of leverage on successive rolls. And in exchange for that risk I have more valuable optionality and less skewness risk. You take issue with that?

I think of the put as insurance. So the way I would phrase it is that high-deductible insurance is a lot cheaper than no-deductible insurance. A far-out-of-the-money put (embedded in a deep-in-the-money call) has a tremendously large "co pay", so the insurance comes very cheap. An at-the-money put embedded in an at-the-money call has no deductable and no co-payment, so therefore it is far more expensive. This is priced like insurance, because that's what it is.

In other words, it was all just a very elaborate illusion. They looked like "6 year" warrants, but all the gains from them will come during the final couple of years. So if you can't stomach holding a two year deep-in-the-money option then you'll never profit from the leverage within these warrants. You'll sell them just when they begin to offer some upside. So they are effectively the same risk profile as 2 year deep-in-the-money options on fully-valued stock price due to the fact that they don't begin to outperform the common until that time. And you can find in-the-money 2 year options on Berkshire Hathaway if that game pleases you. But that sounds like a bad Rick Guerin story.

A 2 yr LEAP can be extended indefinitely by rolling. I can roll that thing along for the rest of my life. You rushed in and locked in all 6 years when it was at-the-money and with high implied volatility, I decided to dip my toe in knowing that I would only come out worse off if the volatility had gone even higher on successive rolls and if the stock were still near strike each time. I took that minor risk in exchange for being rewarded if the stock did in fact move. Compare that to your risk where you would not benefit from any such move. You made a conscious choice to give up any big price spike in the first year or two in exchange for participation in future returns after that. However by your own admission you will deem it too risky to continue to hold the position during it's final two years. Thus, you'll never get paid for all this risk you took on! The price of the non-recourse leverage is the only consideration, not the duration. Durations can be extended. You were happy to pay 13% year for years 3,4,5,6, and I passed because those prices absolutely sucked under the scenario that you and I decided to get leveraged for back when the stock was at $12 -- we both decided to leverage at that time because we were unwilling to wait two more years for fear that the stock would climb and get away from us... the very scenario under which you would not get paid anyhow.

Well, we disagree because the idea was just plain stupid -- to choose an instrument that was leveraged but which would not provide a decent leveraged return for you if stock movement to IV occurred suddenly (in the first year or two). You might as well have just held the common all along with the idea that you would swap it for the warrant after the revaluation. Or if the stock remained flat during that time, swap the common for the warrant after the decay had occurred and skewness risk had lessened (fewer years remaining). Now you're stuck leveraging into a deep-in-the-money stock that is much closer to fair value and time is running out. Imagine in two years from now if the stock is at $22. Seriously, would you normally leverage almost 2:1 into a mostly fairly valued stock with a deep-in-the-money put that expires in just two years? And I said this towards the beginning of the thread! I said that skewness would destroy the leveraged returns on the first big revaluation, and then you'd be too chickenshit to continue to hold it when the stock is fully valued with just a year or two remaining and the strike is only $13 (or less after dividend adjustments). So it's a pointless trade... 1) you make nothing from your leverage on a big jump early on... 2) you take the risk of complete wipeout if the stock crashes back to strike at expiry 3) you prepay for a $13 put for that last year or two even though if the stock has recovered by then you'll never have the guts to continue holding on. That's because you don't normally leverage into fully valued stocks with relatively short-term options on a deep-in-the-money basis None of that is said with hindsight. I said it all upfront. It was all wholly predictable. 1) Why be leveraged at that point in time if any big gains from such leverage would be wiped out? That's completely pointless. What were you thinking? Worse than that, you took the risk of underperforming the common on such a move. At the start of the thread I pointed to the way a bank with less uncertainty (Wells Fargo) was valued, and how it's in-the-money warrants were valued. The risk of BAC clearing up the uncertainty (settling lawsuits, running off bad loans and reducing expenses, retaining earnings to boost capital) was that the stock would rise as a result and BAC's implied volatility would drop (irrespective of VIX). Add skewness to that, and you just got your ass kicked.

You borrow money for 5% interest rate, and you invest the proceeds in an asset that returns 10%. The spread is the profit.

Precisely as I've explained it in the past. We agree. The $30 call is effectively a $30 strike put married to a share of common. The option premium is the little bit of skin in the game... Additional payment to the lender comes in the form of the eroding put as the stock increases... if it ever does. He has a huge profit share in exchange for accepting such a small premium. Maybe he is Rumpelstiltskin??? The tiny premium is the straw that he will spin into gold in return for your first born child.

The problem with short term options is that their cost of leverage is normally too high for my taste. For example, February 2015 BAC $17 put is 43 cents, and the Jan 2016 is $1.52. The first two months costs 43 cents, and the next 11 months cost only $1.09. That last 11 months comes at roughly 2.5 times the price of the first two months for 5.5 times longer duration. The shorter duration call carries more expensive cost of leverage by a country mile. Are you paying attention ni-co? ;) The longer dated put has a lower cost of leverage than the shorter dated put. I get a bit of a discount for taking on skewness risk. Which is why the warrants were such a lousy deal -- the cost of leverage was not only high, but it was the same as with the 2 year options. BAC was very volatile, a 1 or 2 yr option was plenty of time to camp out waiting for the stock to move up or down. And those 2 year options carried the same cost of leverage as with the warrants, so you weren't paying a premium for the flexibility. Optionality is valuable, and shorter duration options have more optionality. That's why they are more expensive. Clear?

The warrant holders would be no better off. They are just sort of stuck. However, I could take advantage of this gift-from-market-gods by rolling my puts to a lower strike. Or by keeping the strike at $12 and use skewness to my benefit by getting a better price when rolling. Just like I can take advantage of the recent price rise by rolling to a higher strike or rolling my $12 puts inexpensively. Same difference. Example of rolling to lower strike after stock has declined by $4 from $12 to $8... 1) purchase new $8 strike put and sell the initial $12 put, thereby locking in the profit on the $12 put. It will get even more exciting later when stock rallies up to $12 and you either roll your $8 strike put up to $12 again, or use skewness to your benefit and get a cheap premium rolling the $8 strike put along 2) The lower the stock goes, the better it gets. This is why the warrants should have been cheaper, they had less optionality and thus were less valuable in times of stock price volatility

There are only two costs to the cost of leverage -- the implied put and an interest rate forecast. You can back out the interest rate assumptions (maybe using 4 yr bond yields as a proxy) and the rest would be the put. There isn't much skewness risk to discount today because $13 strike puts are relatively useless and priced as such. So that very reason is why I like the warrants -- the value of the implied put would soar in a market crash. See, if the stock goes up 10% a year from here until expiry, you'll make a spread of 5% a year over the present cost of leverage. However, if instead the stock drops back to $12 again in a crash next week, you'll likely see the warrants go back to 13% cost of leverage again. So multiplied by 4 years, that would cushion your fall by 32%. In other words, you likely have the same downside risk as the unleveraged common in a big crash back down to $12, but you have leveraged upside if the stock returns more than 5% a year from here. So... before it was nearly impossible to win and now it's much harder to lose. These warrants don't carry skewness risk when stock price is already very askew relative to warrant strike.

That's a misunderstanding of my message. It gets cheaper to roll an initially at-the-money put after the stock breaks hard either up or down further away from strike. For example, if you own the 2015 $17 strike put today and you wish to roll it out to 2016 $17 strike put, it will cost you an extra $1.25. $1.25 is 7.35% of $17. Okay, but lets say the stock plunges to $5 per share tomorrow morning before you roll it. You existing put will be very deeply in the money, and you'll likely be paying only 25 cents or something in additional premium when you trade it for the 2016. Skewness is what would drive the premium for the extra 12 months down to only 0.25 from 1.25 initially. So that's why a greatly lower stock price would make my cost of leverage cheaper. You talked about calls in your question, but in every call there is a hidden put. Same principle applies -- rolling an out-of-the-money call is cheaper than rolling an at-the-money call. Entirely due to the value of it's hidden put.

I think it would be better if I use live numbers to explain the skewness risk... Today's Jan 2016 pricing... $17 strike put for $1.52 is 8.9% of strike $15 strike put for 0.84 is 5.6% of strike $12 strike put for 0.31 is 2.6% of strike $10 strike put for 0.17 is 1.7% of strike So do you see the pattern? An at-the-money put has a lot of value because it protects all of your equity, but a very far out of the money put has practically no value -- because it doesn't protect a huge chunk of your equity. The difference in pricing between the $12 and the $17 is 630 basis points. So.... The moral of the story is that for a stock where... 1) you think it is very undervalued (and at high risk of a large revaluation within a couple of years) 2) somebody offers you at-the-money options for a very, very, very long term with no discount for skewness risk 3) the initial volatility priced into the put is relatively high ... run like hell! :D That 630 basis points is multiplied across every remaining year left in the warrant. The longer the term, the greater your pain. A 30 yr warrant if it got hit by 630 basis points per year would cost you... 189% These movements from skewness greatly dominate -- everything else is dwarfed. Which is why for very long term at-the-money warrants you should demand a margin of safety to account for skewness risk. ni-co has been saying completely the opposite. NOTE: I deviated in this post to save time, expressing the premiums as a % of strike rather than as the contribution to cost of leverage. Just being lazy.

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.

Investor Relations page has a link to Moynihan's talk today: a webcast.

I had closed the IWM short earlier in the year, and then put it back on at $117 a month ago. The short is hedged with $130 strike call. About 120% of account net asset value. I also have a SPY short for 50% of account value that isn't hedged. Then I have a lot of BAC common hedged with $15 strike 2016 puts and a few small energy positions.

I don't know, but here's a good anthem to hum: Stand up in a clear blue morning Until you see What can be Alone in a cold day dawning, Are you still free? Can you be? When some cold tomorrow finds you, When some sad old dream reminds you How the endless road unwinds you ? While you see a chance take it, Find romance fake it Because it's all on you Don't you know by now no one gives you anything Don't you wonder how you keep on moving One more day your way When there's no one left to leave you, Even you don't quite believe you That's when nothing can deceive you Stand up in a clear blue morning Until you see What can be Alone in a cold day dawning, Are you still free? Can you be? And that old gray wind is blowing And there's nothing left worth knowing And it's time you should be going