warrants for leveraged GARP investing

[ERICOPOLY]

 

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.

 

I think "cheering" is probably the investing equivalent of gallows humor... okay, yes I root for a higher stock price of course like everyone else.  What I meant is that it's a better outcome than having to roll-at-the-money where the extrinsic value would be relatively higher.

 

And if the stock goes low enough I can roll to a lower strike without increasing my average cost of financing.  Like let's say the stock drops to $7, I'm pretty sure I could roll my initial $12 strike put down to the $10 strike, or $9 strike without the per-annum financing costing me any more than it did in the first place when the stock began at $12.

 

So to me, instead of a stock being flat it works out far better to first have the stock drop by a lot if I started out being hedged with an at-the-money put.

 

Psychologically though, I'd rather skip that drama and have the stock go up rapidly instead.

[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.

 

I think "cheering" is probably the investing equivalent of gallows humor... okay, yes I root for a higher stock price of course like everyone else.  What I meant is that it's a better outcome than having to roll-at-the-money where the extrinsic value would be relatively higher.

 

And if the stock goes low enough I can roll to a lower strike without increasing my average cost of financing.  Like let's say the stock drops to $7, I'm pretty sure I could roll my initial $12 strike put down to the $10 strike, or $9 strike without the per-annum financing costing me any more than it did in the first place when the stock began at $12.

 

So to me, instead of a stock being flat it works out far better to first have the stock drop by a lot if I started out being hedged with an at-the-money put.

 

Psychologically though, I'd rather skip that drama and have the stock go up rapidly instead.

 

So let's be clear, this is your perception of the situation, right? - as there can be no instance where the stock price drops and you are better off. And I don't mean this in a negative way, because having a mental framework that helps perceive losses more positively when dealing with leverage and options can be helpful in practice.

[ERICOPOLY]

 

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.

 

I think "cheering" is probably the investing equivalent of gallows humor... okay, yes I root for a higher stock price of course like everyone else.  What I meant is that it's a better outcome than having to roll-at-the-money where the extrinsic value would be relatively higher.

 

And if the stock goes low enough I can roll to a lower strike without increasing my average cost of financing.  Like let's say the stock drops to $7, I'm pretty sure I could roll my initial $12 strike put down to the $10 strike, or $9 strike without the per-annum financing costing me any more than it did in the first place when the stock began at $12.

 

So to me, instead of a stock being flat it works out far better to first have the stock drop by a lot if I started out being hedged with an at-the-money put.

 

Psychologically though, I'd rather skip that drama and have the stock go up rapidly instead.

 

So let's be clear, this is your perception of the situation, right? - as there can be no instance where the stock price drops and you are better off. And I don't mean this in a negative way, because having a mental framework that helps perceive losses more positively when dealing with leverage and options can be helpful in practice.

 

Compare A to B (both of them 3 month period with $12 strike at-the-money put):

 

A:  stock trades flat at $12 for 3 months

B:  stock drops to $7 after 1st month, I then roll to longer duration $10 strike put, and then stock goes back to $12

 

Although stressful, I'm better off under scenario B.

 

I now have $2 gap between stock and strike under scenario B, and in exchange I only had to buy one more year's worth of extrinsic value when I rolled.  And the extra year of extrinsic value was relatively cheap because the $10 strike was far above the $7 stock price at the time.  That big gap between $7 and $10 protects me from the implied volatility spike.  It should also compensate for the added cost in extrinsic premium that needs to be paid in rolling the existing portion of the term -- if not, then roll only a portion of them to the $10 strike and roll the rest at $12 strike.  The $7 stock price is so far from $12 that significant saving is to be realized in rolling $12 strike extrinsic premiums to longer terms.  That savings can be used to afford a lower $10 strike for some if not all of them is my point.

 

Plus, going forward into future years I will be able to roll the $10 put along in scenario B.  That will be cheaper than rolling along the $12 put from scenario A.

 

 

[ERICOPOLY]

And I don't mean this in a negative way, because having a mental framework that helps perceive losses more positively when dealing with leverage and options can be helpful in practice.

 

This is covered well by my "cost of leverage" mental modeling of the extrinsic option value.

 

I think of it as pre-paid interest for non-recourse leverage because I don't intend to exit the trade before the option expires.

 

And interest payments on leverage are 100% losses, right?  Yes, you watch it vaporize quickly MTM, but this is money that already is mentally banked as a 100% loss.

 

So if I'm putting together a plan to leverage up on BAC stock non-recourse and hold it for years until it fully plays out, then I know that those extrinsic option premiums are 100% losses.

 

Just like when Fairfax took on debt to buy ORH, their interest payments are 100% losses.

 

They are the "cost" of the leverage. 

 

I'm not in the game to profit from spikes in extrinsic option value.  I'm in the game to profit from spikes in the stock price that exceed the cost of leverage over a period of many years. 

 

So if the extrinsic value gets slammed by a near term stock price plunge, I can use that as an opportunity to extend the term of my options while the extrinsic value is cheap and on sale.  In the long run, this increases my profits because it reduces the average cost paid for my leverage.

 

[jmp8822]

 

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.

 

How much would you allocate to puts for the first 100% of the portfolio, if any?  I understand that you would like to have the last 50% fully non-recourse, to protect your capital, only having to pay the 'interest cost'.  Is there a reason why you would ever have the 1.5x fully hedged at the money or perhaps you might hedge for a 25 or 50 percent loss on the first 100% of capital? (I tend to own just one or two stocks to avoid opportunity cost, which is where that question comes from)

[leadingusforward]

 

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.

 

Eric - Thanks for all the time you put in to explaining these concepts.  Your clearly laid out examples help put these ideas at the Forest Gump level.  You are performing a real public service on this board.

 

The cost of the non-recourse leverage would only wipe you out if the stock remained fairly flat, correct?

[original mungerville]

And I don't mean this in a negative way, because having a mental framework that helps perceive losses more positively when dealing with leverage and options can be helpful in practice.

 

This is covered well by my "cost of leverage" mental modeling of the extrinsic option value.

 

I think of it as pre-paid interest for non-recourse leverage because I don't intend to exit the trade before the option expires.

 

And interest payments on leverage are 100% losses, right?  Yes, you watch it vaporize quickly MTM, but this is money that already is mentally banked as a 100% loss.

 

So if I'm putting together a plan to leverage up on BAC stock non-recourse and hold it for years until it fully plays out, then I know that those extrinsic option premiums are 100% losses.

 

Just like when Fairfax took on debt to buy ORH, their interest payments are 100% losses.

 

They are the "cost" of the leverage. 

 

I'm not in the game to profit from spikes in extrinsic option value.  I'm in the game to profit from spikes in the stock price that exceed the cost of leverage over a period of many years. 

 

So if the extrinsic value gets slammed by a near term stock price plunge, I can use that as an opportunity to extend the term of my options while the extrinsic value is cheap and on sale.  In the long run, this increases my profits because it reduces the average cost paid for my leverage.

 

I agree with this, I do this as well - it is a cost of doing business.

[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.

 

I think "cheering" is probably the investing equivalent of gallows humor... okay, yes I root for a higher stock price of course like everyone else.  What I meant is that it's a better outcome than having to roll-at-the-money where the extrinsic value would be relatively higher.

 

And if the stock goes low enough I can roll to a lower strike without increasing my average cost of financing.  Like let's say the stock drops to $7, I'm pretty sure I could roll my initial $12 strike put down to the $10 strike, or $9 strike without the per-annum financing costing me any more than it did in the first place when the stock began at $12.

 

So to me, instead of a stock being flat it works out far better to first have the stock drop by a lot if I started out being hedged with an at-the-money put.

 

Psychologically though, I'd rather skip that drama and have the stock go up rapidly instead.

 

So let's be clear, this is your perception of the situation, right? - as there can be no instance where the stock price drops and you are better off. And I don't mean this in a negative way, because having a mental framework that helps perceive losses more positively when dealing with leverage and options can be helpful in practice.

 

Compare A to B (both of them 3 month period with $12 strike at-the-money put):

 

A:  stock trades flat at $12 for 3 months

B:  stock drops to $7 after 1st month, I then roll to longer duration $10 strike put, and then stock goes back to $12

 

Although stressful, I'm better off under scenario B.

 

I now have $2 gap between stock and strike under scenario B, and in exchange I only had to buy one more year's worth of extrinsic value when I rolled.  And the extra year of extrinsic value was relatively cheap because the $10 strike was far above the $7 stock price at the time.  That big gap between $7 and $10 protects me from the implied volatility spike.  It should also compensate for the added cost in extrinsic premium that needs to be paid in rolling the existing portion of the term -- if not, then roll only a portion of them to the $10 strike and roll the rest at $12 strike.  The $7 stock price is so far from $12 that significant saving is to be realized in rolling $12 strike extrinsic premiums to longer terms.  That savings can be used to afford a lower $10 strike for some if not all of them is my point.

 

Plus, going forward into future years I will be able to roll the $10 put along in scenario B.  That will be cheaper than rolling along the $12 put from scenario A.

 

What if in B the stock does not go back to $12 and it goes to $10, and you have to roll - no advantage. 1) The advantage the above provides is you roll at a longer maturity when the extrinsic cost is low, that makes a lot of sense and is an important advantage - for example in B you could have rolled at a strike of $12 at a longer maturity when the stock was at $7 and have achieved cheaper financing. 2) A secondary, less important outcome, is when you roll at a lower strike, you are in essence increasing your bet on the stock, because i) your portfolio gains when the stock rises past $10 (neglecting other costs for simplicity) - instead of gaining only when it passes $12 as in A; and ii) your portfolio will lose more than in A if the stock decreases further because you paid higher extrinsic cost buying the put at $10 versus rolling it at $12.

 

On this basis, 2) could be viewed as you economically increasing your bet/exposure to the stock. 1) Is an advantage, but to be in a position to benefit, your original put LEAP can not be the longest put LEAP out there (ie 2 years) because otherwise, you can't roll longer term to take advantage (unless there is a longer term warrant out there which is not usually the case). So you would have to buy the near term put LEAP (eg, 1 or 1.25 years to maturity) originally. Not sure what you do, but do you usually buy the one year LEAP? I guess if you do you can take advantage, but the problem with the one year LEAP is it usually costs more in extrinsic value than the 2 year LEAP I believe (maybe 60-65 cents for the one year, and $1 for the two year), so you have to screw yourself initially on costs to be able to take advantage of 1).

 

So based on that logic (which I could be wrong on) I don't see anything other than your perception - at this level of detail in our analysis. Am I missing something or making sense here?

 

 

 

[original mungerville]

I guess for 1), if you buy the 2 year LEAP put originally (which I would assume you may often do), then you can take advantage when the new 2 year LEAP comes out - but you don't want to wait that long, so you probably have about a 3 to 6 month window every year to take advantage of a stock drop.

 

Its still a good advantage, but one that can be exercised only parts of the year. Is that fair?

[jay21]

But I'm convinced that leverage is an underappreciated tool to achieving superior returns.

 

Agree 100%. I have been racking my brain constantly trying to find a LT non-recourse funding source but have yet to find anything.  Eric has a great idea of using a combo of puts and margin, which could work.  I am waiting for more depressed prices before I think about it more seriously.

 

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

[peter1234]

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

 

If you are thinking of Leaps instead of warrants, I don't think that would happen in his funds as he does not use options. (The warrants seem to be as far into 'derivative land' as he will venture.)

 

His other vehicles, like his foundation, might be different.

[ERICOPOLY]

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

 

The GM warrants didn't and still don't carry much premium.  Mohnish therefore wasn't taking on MTM risk with the premiums.

 

Most of the leverage cost with the GM warrants comes from the missing dividends.  That get paid over time as the dividends are missed, not upfront as a premium.

 

The point Mohnish made about those warrants was that there was hardly any premium.

[ERICOPOLY]

I guess for 1), if you buy the 2 year LEAP put originally (which I would assume you may often do), then you can take advantage when the new 2 year LEAP comes out - but you don't want to wait that long, so you probably have about a 3 to 6 month window every year to take advantage of a stock drop.

 

Its still a good advantage, but one that can be exercised only parts of the year. Is that fair?

 

Yes.  That's fair.

 

In March 2013 I sold all of my warrants when the stock was at $12 and I switched over to leveraged common with puts.

 

My puts were January 2014 expiry, so my situation is exactly what I've been arguing -- a big price swing would be a chance to roll cheaply to a longer term.

 

So I passed on the 2015 options and went with the 2014 instead.

[karthikpm]

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

 

The GM warrants didn't and still don't carry much premium.  Mohnish therefore wasn't taking on MTM risk with the premiums.

 

Most of the leverage cost with the GM warrants comes from the missing dividends.  That get paid over time as the dividends are missed, not upfront as a premium.

 

The point Mohnish made about those warrants was that there was hardly any premium.

 

Would you consider buying the GM warrants now?

[jay21]

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

 

The GM warrants didn't and still don't carry much premium.  Mohnish therefore wasn't taking on MTM risk with the premiums.

 

Most of the leverage cost with the GM warrants comes from the missing dividends.  That get paid over time as the dividends are missed, not upfront as a premium.

 

The point Mohnish made about those warrants was that there was hardly any premium.

 

Ok, haven't checked the quote in a while but Im assuming then it is OK? He's basically buying GM at a lower cost correct? Because he gets $ for $ movement? When I think about it like that, I like it more.

 

Id assume most warrants have this behavior when they move further in the money. Therefore, your return faces a headwind as your premium amortizes down as price reaches IV.

 

 

[jay21]

Eric - great work. Any chance you convince Mohnish to switch out the GM warrants?

 

The GM warrants didn't and still don't carry much premium.  Mohnish therefore wasn't taking on MTM risk with the premiums.

 

Most of the leverage cost with the GM warrants comes from the missing dividends.  That get paid over time as the dividends are missed, not upfront as a premium.

 

The point Mohnish made about those warrants was that there was hardly any premium.

 

Ok, haven't checked the quote in a while but Im assuming then it is OK? He's basically buying GM at a lower cost correct? Because he gets $ for $ movement? When I think about it like that, I like it more.

 

Id assume most warrants have this behavior when they move further in the money. Therefore, your return faces a headwind as your premium amortizes down as price reaches IV.

 

Actually, Im thinking through this in more detail and it might be helping me see your point about a "synthetic put".

 

If the premium amortizes as you go ITM, then the opposite might be true. You accrete a premium as you move out of the money. So at some point your losses won't be $ for $ as you will be gaining a premium.

 

EDIT: I need to pull out my old option graphs. Price as a function of strike, time, etc.

[ERICOPOLY]

What if in B the stock does not go back to $12 and it goes to $10, and you have to roll - no advantage.

 

I could sell the $10 extrinsic value for the relatively larger at-the-money premium and roll it along back to the $12 strike.

 

I therefore have benefitted from changes in extrinsic value even if I gained no intrinsic value.

[Mungerville]

What if in B the stock does not go back to $12 and it goes to $10, and you have to roll - no advantage.

 

I could sell the $10 extrinsic value for the relatively larger at-the-money premium and roll it along back to the $12 strike.

 

I therefore have benefitted from changes in extrinsic value even if I gained no intrinsic value.

 

Eric,

 

You are starting at the most expensive spot on the spectrum of extrinsic value for a given maturity. So odds are the stock moves and doesn't stay at that exact spot and so you feel good because you roll with a longer maturity at cheaper annual extrinsic value cost. But are you sure your starting spot is rational? 

 

I guess the alternative is buying a somewhat out-of-the-money put (because in-the-money gets you into the warrant issue where you trade undervaluation for cheaper non-recourse financing). In this case, extrinsic costs are lower initially, however the stock could move up or down in the short term - let's say 50/50 chance so there is probably 50% odds in the short-term that were you to roll, it would cost you more extrinsic value (and 50% odds it would cost you less). And one would think over say 15 months the stock would probably have greater chance of moving up rather than down if the security selection made sense.

 

In any case, I just don't see any advantage to starting where you start on the spectrum - it may even be suboptimal (I don't know) - but there is value in rolling to longer maturities when the stock moves away from the strike. Would you agree with these two points?

 

[ERICOPOLY]

In any case, I just don't see any advantage to starting where you start on the spectrum - it may even be suboptimal (I don't know) - but there is value in rolling to longer maturities when the stock moves away from the strike. Would you agree with these two points?

 

Sure, it may not be optimal.

 

I find it less stressful. 

[original mungerville]

In any case, I just don't see any advantage to starting where you start on the spectrum - it may even be suboptimal (I don't know) - but there is value in rolling to longer maturities when the stock moves away from the strike. Would you agree with these two points?

 

Sure, it may not be optimal.

 

I find it less stressful.

 

Less stressful can make a huge difference in practice though.

[namo]

And so the warrant will be overpriced if you put any significant sum into the valuation of it's (mostly useless) put.

I've seen this mentioned here and in the BAC leverage thread (which I'm 10 pages into...but it's tens of pages long), but I haven't read the explanation yet: why do you say there's a put included in the warrants? Because of the time value/implicit volatility residue that props up its value even when it's out of the money?

 

Thanks for the insights on the topic of leverage!

[ERICOPOLY]

And so the warrant will be overpriced if you put any significant sum into the valuation of it's (mostly useless) put.

I've seen this mentioned here and in the BAC leverage thread (which I'm 10 pages into...but it's tens of pages long), but I haven't read the explanation yet: why do you say there's a put included in the warrants? Because of the time value/implicit volatility residue that props up its value even when it's out of the money?

 

Thanks for the insights on the topic of leverage!

 

A warrant is a call option issued by the company.  What is it other than the synthetic marriage of the common stock with a put?

[Sunrider]

Eric,

 

Perhaps you should read more closely what people say. You really assume that people (me included) don't understand what you're trying to say? If that is so then you just confirmed what a lot of people here probably think about you attitude. What it is I don't know, but I can tell you what it comes across as: conceited. That was the main point of my last post. It is the point of this post. Your musings on this topic are valuable, the way you put other people down who don't agree with your ASSUMPTIONS (I don't think many people have disagreed with the argument/logic - what people take exception to is that you gloss over the implicit assumptions you have made and don't acknowledge that) is what is not in the spirit of this board.

 

So back to your argument - hypothetically speaking (to move away from BAC). If I assume that LTS.TO or PWE will survive and the oil price will be higher in the future ... should I buy 2 year LEAP or a 5 year warrant (assuming it did exist). Your answer to this question will depend on ... what? I think:

 

- your "cost of leverage" (which is really another way of saying the expected vol the market prices into both instruments, which incidentally will relate to the time to expiration as well); and

- the assumed timing of the oil price rise.

 

Anything I'm missing? If not then I predict that all things equal you'll tell me to invest in the LEAP rather than the longer term warrant as long as you expect that oil will go higher before the expiry of the LEAP.

 

Magic! I can read your mind.

 

 

 

 

 

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.

[Sunrider]

I call BS on your points below - except for the one about the flatlined stock price. Go back to the other threads, that's exactly what people have been debating you on. You assume:

1. that this scenario will not happen (or has low enough probability so you're happy to take the risk); and

2. that in a scenario where the stock is volatile you roll at the right times.

 

Assumptions, assumptions ...

 

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.

[Sunrider]

Yeah, even if you didn't take finance classes you'll intuitively know that an option with Strike = 100 will behave more strongly when the stock is at 100 than when the stock is at 10 or at 200. What's new?

 

 

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!!!