warrants for leveraged GARP investing

[ERICOPOLY]

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.

 

[ERICOPOLY]

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.

[ERICOPOLY]

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.

[ERICOPOLY]

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.

[HJ]

Not that I have any particular insights into the technical valuation models of a generic warrant.  But I'm convinced that leverage is an underappreciated tool to achieving superior returns.  The standard warning is don't buy things with borrowed money, but if you look carefully, away from the tech / VC world, it's almost as if most wealth is generated through leverage.  (Perhaps this is just me reading the Davis Dynasty where the first pot of gold was made with buying insurance company on margin debt, no less).

 

Leverage may not be in the form of a listed readily accessible instrument like a warrant or an option, but whether it's in real estate or private equity, Buffett / Watsa / Markel with their insurance company, non mark to market long term leverage is the glue that binds.  Of course it's important to find the right instrument to leverage with to start.  Beyond that, how does one think about long term volatility that is priced into an at the money warrant, vs. short term options volatility which arguably is more of a market sentiment indicator vs. control premium that a private equity investor is willing to pay to take a company private (which is probably more related to changing the fundamental operating characteristics of a business) vs. credit spreads on high yield bonds and leveraged loans.

 

This comment probably veers off the rails a bit from the reason you started this thread.  But you had me at the title of the thread "leveraged GARP".

[ERICOPOLY]

Beyond that, how does one think about long term volatility that is priced into an at the money warrant

 

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.

[karthikpm]

ERICOPOLY,

 

Thanks for that nice explanation. I wish I had read it  before buying BAC WTA . I have a large position in the common stock, but added warrants without understanding the issue .

 

[HJ]

Beyond that, how does one think about long term volatility that is priced into an at the money warrant

 

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.

 

Agreed, and he made sure he can't be margin called except only at maturity.  When you think about who's on the other side of those trades, (life insurers, or whoever has those "minimum guarantees" in their variable annuity contracts), the buyers of those puts were not evaluating those transactions based on the pure economic merits of the transaction, but forced by their accounting regime to satisfy an arbitrary regulatory capital constraint.  Of course it's easier to look at the transaction in hindsight, but not many people could have done that trade, the pricing of which is not necessarily driven by the economics of the trade itself, but by one's own capacity to hold the position to maturity.

 

When I think about the "term structure" of volatility, I tend to draw comparison to a somewhat analagous "term structure" of credit spreads.  The typical term structure of credit of course is positively sloped, with lower spread for shorter term paper than longer term paper.  As a borrower, most of the time it's economic to ride down the positive yield and spread curve, i.e borrow short than long.  The draw back to the strategy would be if you can't roll the borrowing upon maturity, i.e. credit spreads blow out, new issue market gets illiquid.  For volatility, it probably also mostly make sense to string together a bunch of 1 yr options vs. a 6 yr warrant.  But as the strike moves more and more in the money, the warrant premium decays, but the bid/ask of a deep in the money option (easily half a point to a point) also becomes friction in stringing the options together.  In all fairness, to truly replicate the exact 6 yr warrant exposure through 6 1-year optioin as the strike move more and more in the money can be a costly exercise.  But then again you may chose not to replicate the exact same strike the entire 6 yrs.  In the circumstance you move the strike over time in lock step with the stock, what you don't lose in bid/ask may be more subject to premium decay as your strike in the new option is closer to the then current stock.

 

Whatever the case, it is certainly true that the market pricings of these instruments are also affected by the nature of the different buyer base.  In the case of 1 yr options (leveraged investors) vs. the buyer base of these 6 yr warrants (investors + the banks themselves, which would achieve the same repurchase goals much more effectively through buying these warrants than stocks).  So it also wouldn't be surprising if in hindsight, the warrants are priced a bit richer than the options. 

[ERICOPOLY]

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.

[Mungerville]

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.

 

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)

 

 

[ERICOPOLY]

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.

 

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.

[rayfinkle]

eric- agree with mungerville. such a clear framework.

[original mungerville]

Eric,

 

It was getting too painful for me to watch!

 

With the route you are endorsing, if for some reason the stock drops, your financing gets more expensive.

 

Well, presumably, if you are right on the stock, a more expensive re-financing then financing a more deeply undervalued security isn't exactly the end of the world either, is it? As at that point the spread between your percentage annual financing cost and your expected annual average percentage gain on the notional you are referencing has increased - ie your net annual expected profits on a percentage basis relative to your notional exposure have actually increased (not decreased). 

 

The key is primarily being right on the undervaluation of the security and, secondarily, having a reasonable time frame for the most material part of its revaluation - could be 1 year, could be 5 years - but in my experience for a large cap its usually been around 1.5 years on average, and for a mid-cap maybe 2-3 years. I think before you enter into the arrangement, you always have to have a plan if the stock drops, volatility increases materially, etc. Its important to think through these scenarios so you are able to act correctly. You basically need to know exactly how you are going to operate before entering into the arrangement.

 

 

[ERICOPOLY]

Eric,

 

It was getting too painful for me to watch!

 

With the route you are endorsing, if for some reason the stock drops, your financing gets more expensive.

 

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.

 

[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.

[ERICOPOLY]

I will use an example of extremely high record breaking implied volatility.

 

Before the financial crisis, an at-the-money $30 strike WFC put cost about $3.

 

At the height of the panic in March 2009, the at-the-money $8 strike option had an extrinsic value of roughly $3.  And while that was happening, the extrinsic value of the $30 strike option was FAR LESS than $3.

 

Skewness was WAY MORE dominant than implied volatility.  The price of straw is pushed down by the weight of the first born child.

 

When the stock was at $8, the first-born-child weighed $22 for that $30 strike option.  That's a weighty child!!!

[original mungerville]

I understand Eric, that is because you are keeping your strike at 12. But your framework for how to look at that is very interesting. Do you always buy at-the-money strikes to begin with...And continue at that same strike? I'm really interested in your answer here - is this your general bread and butter approach going in - because that is interesting.

 

Or do you buy slightly in-the-money options to begin so you don't pay much for the "extrinsic" value?

 

I have been doing the latter mostly (to reduce this extrinsic / implied annual financing cost) but wondering what you think.

 

My comment in my last post relates to the situation where you start with a strike at 10 (in-the-money to reduce extrinsic costs) with stock say at 14; then the stock falls to 10, and you roll at a strike of 10. So your financing cost went up (the long-term warrant might start to look a little better in this scenario - at least superficially), however, the stock is more undervalued so although the financing costs went up with the roll, your net profits percentage-wise are increased (because the likely percentage annual gain on the notional from a revaluation of the stock went up more drastically). This was the scenario I had in mind with the last post, and that was the point. Do you agree, its not the end of the world - even from this perspective. From your other perspective, its actually helpful. Here as well, its helpful viewed in this way.

 

[ERICOPOLY]

I understand Eric, that is because you are keeping your strike at 12. But your framework for how to look at that is very interesting. Do you always buy at-the-money strikes to begin with...And continue at that same strike? I'm really interested in your answer here - is this your general bread and butter approach going in - because that is interesting.

 

Or do you buy slightly in-the-money options to begin so you don't pay much for the "extrinsic" value?

 

I have been doing the latter mostly (to reduce this extrinsic / implied annual financing cost) but wondering what you think.

 

My comment in my last post relates to the situation where you start with a strike at 10 (in-the-money to reduce extrinsic costs) with stock say at 14; then the stock falls to 10, and you roll at a strike of 10. So your financing cost went up (the long-term warrant might start to look a little better in this scenario - at least superficially), however, the stock is more undervalued so although the financing costs went up with the roll, your net profits percentage-wise are increased (because the likely percentage annual gain on the notional from a revaluation of the stock went up more drastically). This was the scenario I had in mind with the last post, and that was the point. Do you agree, its not the end of the world - even from this perspective. From your other perspective, its actually helpful. Here as well, its helpful viewed in this way.

 

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

My mindset is it keeps my maximum losses from leverage at the cost of my financing.  It costs a bit more extrinsic value, but it simplifies my thinking about the cost.  I know exactly what I am risking and I don't have to predict stock price movements.  Nobody is forcing me to roll these things if the stock hasn't budged -- there is a static maximum cost.

 

And any stock movement (be it up or down) is a friend of my leverage.  Rick Guerin eat your heart out.

 

Deeply undervalued stocks tend not to flatline very long -- so while flatlining is a risk, let's not let our fears get too out of hand is my opinion. 

 

There is nothing all that risky about the way you did things, I just want less to think about and I want to cheer when the stock drops.

 

[ERICOPOLY]

I don't always continue at $12.

 

I roll to higher strikes as the stock rises.  But of course that's entirely at my discretion.  It eliminates the tail risk that the warrants carry.

 

It's a bit like a "cash out" refinance (using a non-recourse loan) to borrow an analogy from real estate.  The increase in strike allows me access to a non-recourse loan for funding my lifestyle.  So I don't have to sell my stock to enjoy my gains (no taxes).

 

People do that kind of thing all the time in real estate -- cash-out refinancing isn't a taxable event.

 

 

[leadingusforward]

 

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

My mindset is it keeps my maximum losses from leverage at the cost of my financing. 

 

Is there any limit you place on how much portfolio margin you're comfortable using while hedging puts?  I know your recent examples of used the same leverage as the warrants, but you could use more.

 

Thanks.

[HJ]

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

Wouldn't text book say this is exactly equivalent to buying call?  I'm not sure what margin rate your broker charge you, but isn't this how text book explain "put-call parity"?

[ERICOPOLY]

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

Wouldn't text book say this is exactly equivalent to buying call?  I'm not sure what margin rate your broker charge you, but isn't this how text book explain "put-call parity"?

 

Correct.  Unfortunately our idiotic tax code treats rolling our profitable calls as a taxable event.  But rolling a devalued put is not taxable.

[HJ]

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

Wouldn't text book say this is exactly equivalent to buying call?  I'm not sure what margin rate your broker charge you, but isn't this how text book explain "put-call parity"?

 

Correct.  Unfortunately our idiotic tax code treats rolling our profitable calls as a taxable event.  But rolling a devalued put is not taxable.

 

Ah.  Thank you for that factoid.  It's worth a lot, wasn't aware of that.

[ERICOPOLY]

 

I stopped buying calls.  Now I use portfolio margin to buy leveraged common and I protect it with at-the-money puts.  So I borrow on margin, but the at-the-money puts make margin borrowing fully non-recourse.

 

My mindset is it keeps my maximum losses from leverage at the cost of my financing. 

 

Is there any limit you place on how much portfolio margin you're comfortable using while hedging puts?  I know your recent examples of used the same leverage as the warrants, but you could use more.

 

Thanks.

 

It's limited by how much I care to lose if the puts expire worthless.  So if you wanted to go 5x leveraged, they'll let you do it.  I think the margin equity limit is only 15% or something.  But the cost of the non-recourse leverage will quite possibly wipe you out.

 

I think 1.5x is a comfortable level.

[original mungerville]

 

My mindset is it keeps my maximum losses from leverage at the cost of my financing.  It costs a bit more extrinsic value, but it simplifies my thinking about the cost.  I know exactly what I am risking and I don't have to predict stock price movements.  Nobody is forcing me to roll these things if the stock hasn't budged -- there is a static maximum cost.

 

There is nothing all that risky about the way you did things, I just want less to think about and I want to cheer when the stock drops.

 

It is simple. So you just max out right away - and basically pay the most extrinsic value possible at a given maturity of put options you are looking at. This is counterintuitive as it leads to high initial financing costs. Then, any movement in the stock price necessarily helps you refinance cheaper when you roll because you already picked the most expensive spot on the spectrum.

 

Borrowing, and buying at-the-money puts in a taxable account is the same as buying an at-the-money call in a non-taxable account. And in both cases, if the stock moves down, you have lost on a mark-to-market in terms of your portfolio. But I guess you are cheering because your extrinsic financing cost on a go-forward basis declines. So your portfolio is down but you are cheering. I guess the question is do you get sad when the stock moves back up to the initial strike price? Probably not. Even though that is inconsistent, you probably don't get too sad because your portfolio is close to break-even at that point (less margin financing costs including time value erosion on the put), and you have hope the stock price moves up past the strike price in short order (before you have to roll again).

 

So coming back to the cheering part, I guess what you mean is that when the portfolio value is down (because the stock price went down), you find comfort in the idea that the put costs you less extrinsic cost as you roll. So basically your portfolio down at present (ie stock down, margin interest paid, put price up but not as much as the stock price is down), but you kinda mentally present value the cost savings on a go-forward of your cheaper go-forward all in financing. And this mentally helps you cope with your portfolio being down at present.