ERICOPOLY

Hey Eric, I just came across this discussion - what did I post in 2006 that triggered something? The summary of the long FFH thesis? At one point near the bottom in 2006 you commented that after many dedicated longs had endured years of pain and held on, somebody new could just walk right up and kill it without having put in the time and paid dues. That comment stuck with me. You were commenting on the whole body of research and discussion up to that point. And it was all free on the internet for anyone to take advantage of in return for nothing. I think this is why Sanjeev stopped putting out for free ;)

First options experience was 2006 FFH. No book, just hands-on. I don't know enough about how businesses work to do original research, so I first watch what the mine-sweepers like (to clear the field of mines) and invest if I can understand the story from 10,000 feet. So the story needs to be clear and simple, and it is brought to me by people who do the screening for mines and booby-traps.

I am waiting for the phone to ring (translation: when a crowd gathers around a given name that I can make sense of). Take away the board and I am a blind man.

The warrant is a synthetically leveraged portfolio. You are comparing it to unleveraged portfolio of common. A $1 price movement results in a higher % impact when leveraged vs unleveraged. So instead, compare it to a leveraged common stock portfolio. Use the same degree of leverage as the warrant.

Semantics. Under that language, a stock with a huge margin of safety cannot be called "cheap". The warrants didn't have a margin of safety priced in. I'm happy to rephrase it as such. The 2 yr options had the same cost of leverage as the 6 yr warrant. No pricing discount for skewness risk. This was a volatile stock. I would characterize the warrant as having been overvalued.

I've never seen that before. Please provide an example. I've only found the opposite to be true.

Don't think about risk so linearly. My strategy isn't locking the put strike at $12 for the entire term. The $17 strike put now costs less than what you paid for your $13.30 strike put. I can roll into it and guarantee to have made a profit, while you are still keeping your position at risk of total wipeout should the stock drop again and not recover before expiry.. No, this is exactly what you couldn't have done – you couldn't have guaranteed it. You can do it now because (1) the stock price went up and (2) volatility went down. If it were exactly the opposite, believe me this put you'd want to roll into would be darn expensive. And what if the dog jumped over the fence? Stock went up on falling uncertainty -- a recipe for soaring volatility. Yes. It went well. So there couldn't have been a risk, I guess. I think we just can agree to disagree on this one. No risk? What the heck? Are you just fucking with me for laughs? The risk to my strategy is the exact one I laid out way before you first posted on this thread -- that the stock would remain tight around the $12 range. The warrant strategy had the risks from skewness and fixed-strike, unable to lock in gains as they come.

Don't think about risk so linearly. My strategy isn't locking the put strike at $12 for the entire term. The $17 strike put now costs less than what you paid for your $13.30 strike put. I can roll into it and guarantee to have made a profit, while you are still keeping your position at risk of total wipeout should the stock drop again and not recover before expiry.. No, this is exactly what you couldn't have done – you couldn't have guaranteed it. You can do it now because (1) the stock price went up and (2) volatility went down. If it were exactly the opposite, believe me this put you'd want to roll into would be darn expensive. And what if the dog jumped over the fence? Stock went up on falling uncertainty -- a recipe for soaring volatility. (sarcasm)

Don't think about risk so linearly. My strategy isn't locking the put strike at $12 for the entire term. The $17 strike put now costs less than what you paid for your $13.30 strike put. I can roll into it and guarantee to have made a profit, while you are still keeping your position at risk of total wipeout should the stock drop again and not recover before expiry..

I don't characterize rolling my initial position into the $2 warrant a "wipe out" when the "something" was purchased for far less than the observable decline in the warrants. I want that to happen! It was the whole point of the defensively minded strategy.

For one thing, arguing that a higher VIX should spike the premium for AIG is like arguing that AIG's stock price should move in lockstep with the S&P500. Or how come PWE stock is down 11% if the oil stocks index is down much less. Interest rate expectations could have an effect both on AIG's stock volatility as it effects both their book value as well as interest income, as well as insurance pricing. Interest rate expectations are also a component of the pricing for the synthetic leverage in the warrant. That was also a quite small put premium to begin with, so skewness on a 13% stock price jump may not necessarily be the dominant factor in the pricing if interest rate expectations change. There is also likely to be movements in the warrant price from randomness.

Yesterday, I thought about adding that we still needed some posts about: 1) I'm waiting for the next 30% decline before the bottom 2) It's a black box, how can you value it? Well... deja vu. I'm new to the board. Did you guys go into BAC before or after Buffett got involved? There's nobody like that to follow into this -- not that I don't respect people on the board but following Buffett is kind of a no brainer That too... Truth is, Buffett can't tell us how long oil will go down. Nobody knows. The upside to that is this is an asymmetrical payoff on an outcome that nobody can predict. The cure to low prices is low prices though. We just need the "how long" to be right, but nobody knows. So you aren't competing against anyone with better information.

Yesterday, I thought about adding that we still needed some posts about: 1) I'm waiting for the next 30% decline before the bottom 2) It's a black box, how can you value it? Well... deja vu. However, I felt better about BAC. And points 1&2 above are perhaps valid this time (in the case of BAC it was years after the crisis and books had been scrubbed)

You subtract warrant price from stock price. The remainder compounds up to the warrant strike at a rate. Add the missed 1 cent quarterly dividend expressed as a percentage of strike. You're done -- that is the cost of leverage. So with more dividends over one cent the cost of leverage is getting cheaper... as the strike is adjusted down. What happens when the difference in stock and warrant price exceeds the strike. Would that happen? Negative cost of leverage??? No. That's just anti-dilution stuff to simulate a reinvested dividend. It doesn't affect cost of the leverage. In a margined account, your margin interest rate is the same whether or not you get a dividend that you reinvest. Same thing with the warrants. Thanks, got it! I think this is the second time you've explained this to me. Appreciate your patience with me on this! I don't blame you. Some bloggers have spread some weird mumbo-jumbo about the anti-dilution provisions as if they are some big secret that the market doesn't understand and thus have some secret hidden value that only the dedicated prospectus readers (like themselves of course) could know about. I have been quietly laughing at them from time to time because the very same prospectus clearly states it to be anti-dilutive provisioning. So did they in fact read it ::) Lol the blogger whom you are referring to also posts on this board! :-X Excellent, this gives the blogger a chance to clear up the misleading information.

Like you say, oil could stay down and this is a zero. I got interested in the sector after reading the recent interview of a man who has seen a lot of these cycles -- T. Boone Pickens. Explains that $100 oil in 12 months wouldn't surprise him. I wanted an option that doesn't expire except upon bankruptcy, instead of putting a relatively larger amount into a safer name like XOM. PWE is kind of like that option. Frees up liquidity this way. I've already lost 1/3 of this money anyhow -- it is earmarked for paying BAC dividend taxes. So only $2 per PWE share is really mine to keep.

You subtract warrant price from stock price. The remainder compounds up to the warrant strike at a rate. Add the missed 1 cent quarterly dividend expressed as a percentage of strike. You're done -- that is the cost of leverage. So with more dividends over one cent the cost of leverage is getting cheaper... as the strike is adjusted down. What happens when the difference in stock and warrant price exceeds the strike. Would that happen? Negative cost of leverage??? No. That's just anti-dilution stuff to simulate a reinvested dividend. It doesn't affect cost of the leverage. In a margined account, your margin interest rate is the same whether or not you get a dividend that you reinvest. Same thing with the warrants. Thanks, got it! I think this is the second time you've explained this to me. Appreciate your patience with me on this! I don't blame you. Some bloggers have spread some weird mumbo-jumbo about the anti-dilution provisions as if they are some big secret that the market doesn't understand and thus have some secret hidden value that only the dedicated prospectus readers (like themselves of course) could know about. I have been quietly laughing at them from time to time because the very same prospectus clearly states it to be anti-dilutive provisioning. So did they in fact read it ::)

You subtract warrant price from stock price. The remainder compounds up to the warrant strike at a rate. Add the missed 1 cent quarterly dividend expressed as a percentage of strike. You're done -- that is the cost of leverage. So with more dividends over one cent the cost of leverage is getting cheaper... as the strike is adjusted down. What happens when the difference in stock and warrant price exceeds the strike. Would that happen? Negative cost of leverage??? No. That's just anti-dilution stuff to simulate a reinvested dividend. It doesn't affect cost of the leverage. In a margined account, your margin interest rate is the same whether or not you get a dividend that you reinvest. Same thing with the warrants.

don't they buy at the same time they are issued via dividend reinvestment? does that make a lot of sense? I don't know. Does a DRIP program ever make sense or does it only make sense under certain criteria? I'm thinking the same thought process could be applied to options. Another way to word the question is, should companies ever have a DRIP program. You should add a DRIP program if you are getting tight on cash and you think this might scare the market less than cutting the dividend. And of course if misleading people in this way doesn't bother your conscience.

You subtract warrant price from stock price. The remainder compounds up to the warrant strike at a rate. Add the missed 1 cent quarterly dividend expressed as a percentage of strike. You're done -- that is the cost of leverage.

And that's why the warrant gets incrementally riskier as you tack on more years with the same cost of leverage for each successive year. We started off this thread with the 2 yr options priced with the same relatively high annual cost of leverage as the 6 yr warrants. That was the key thing... the annual cost should have been a lot lower for the added years in the warrants to compensate for the risk from skewness.

See, the thing is... if you paid 13% a year cost of leverage for a BAC warrant expiring in 2040... and the stock surged after 1 year to $18 (as it did earlier this year) and due primarily to skewness the cost of leverage dropped to 7% (as it did at that time)... You'd be suffering a 6% hit for every year remaining. Thus, since I tacked 21 years onto the life if the warrant in the Moynihan example, you can multiply 21 by 6. So by taking Moynihan's deal, you exposed yourself to an additional 126% cost of leverage for that first year. So... it was early 2014 with 26 years left on the warrant before expiry. That's a total of 156% in addition to the 13% from the one year passage of time. 169% total cost for one year of leverage! Yet the common only went up by 50% ??? And you would take this deal you said... because you would hate to take the risk of higher volatility premiums when rolling... which I argue would only happen if the stock remained relatively flat... a stock that you believed would return 20% a year... you would gladly take on the risk of 169% cost for year one because you worry that after 2 years when the first LEAPS expire the volatility or interest rates might be higher. Yet one thing that boosts BAC's earnings (and stock) is rising rates. And higher stock kills the value of the warrant's put due to skewness!

It doesn't change the cost of leverage. Just like the interest expense that Fairfax incurs on the bonds used to finance the buyout of ORH. They lose 100% of the interest costs. Same with at-the-money LEAPS premium. Return realized on the underlying investment isn't a cost of the leverage. And you base this statement of non-fact on what? This entire thread is dedicated to the valuation of the non-recourse leverage. The put is the "non". That's why I compare it to put+margin versus margin alone. Yeah, I see, you think I do that BECAUSE I'm ignoring that the warrant also has a put component. Nice! :) To avoid the expected massacre of the embedded put due to skewness if the common stock price moves sharply away from the strike price of the warrant's put. And... given that it was at-the-money to begin with, the hit will be most severe and only negative (it can only move further from strike).

What do you mean by this... sorry you are quite a few steps ahead... And how much can one leverage in a portfolio margin account ? (I don't have one). Another option I could look into is to use home equity which is also non-recourse loan (sort of) and yes, buy puts to protect the downside. The portfolio margin account looks at you total "net" exposure on the common sense logic that you can always pay off the loan in a market crash by exercising puts. So if you use $12 of margin loan to exercise the warrant... buy a put contract with at least as high as a $12 strike. You could for example go for a $30 strike and borrow another $18 to spend on hookers and blow -- a form of "cash out refinance". It's done all the time with real estate. Research the matter with Interactive Brokers. Just don't use Reg-T margin as there is no netting out of risk from the puts and you'll get a margin call!!!

Hindsight bias? Why don't you price out what that warrant would cost and compare it to the $12 price of the common stock. The common carries an implicit strike of $0, vs your $13.30 on the warrant. :) :) :)

Here is what I would do if you wish to stay with BAC when warrant matures... Use portfolio margin to purchase the underlying shares and hedge your margin loan with BAC puts. You won't be locked into the low strike straightjacket anymore and you can go with a much higher strike.