warrants for leveraged GARP investing

[Sunrider]

Again, complete and utter BS!!!!

 

Nobody is forcing you to roll your puts? Of course, time will force you! That's what you're paying for when you take a long vs. short dated option.

 

This is what you assumed away so freely in the past. You always assume that you can roll in a way that works for you and that over the time horizon (of all the rolls) the stock will eventually go up (by at least as much as the extrinsic value/cost of rolling). Maybe that'll happen, maybe it won't. You're right that with the warrant you locked in a cost of doing that, with the short options you don't, you traded that certainty for other risks (e.g. how a stock would re-act to a one time large dividend).

 

Just be honest with your readers and label your assumptions clearly. And stop abusing Grimm's fairy tales -- you'd much help the discourse here if you formulated your ideas clearly and in a manner that allows your readers to understand them without need for using analogues.

 

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.

[Sunrider]

if you started with 12puts and you then rolled down to a 10 put, what's so great about it? You put an additional $2 at risk, or looking at it concretely:

 

Jan 16 Bac 15puts are about $1, Common at ~$15. So you do a synthetic call.

1. Stock drops to $7. MTM you're down $6 on the common and put goes to a little over 6 (so net-net you're down by about $1)

2. You refinance to a $10 strike. That'll cost a bit more than $3, so you've "taken out" $3 from the roll. Problem is you've also now put an extra $5 at risk (it'll change your required margin, etc. and you'd have to be prepared for that). You've basically realised at MTM $3 loss. This makes sense only if you believe that the "rubber band of price" is now more likely to snap back to your IV estimate (presumably >$15).

3. Say you do, so you continue this game and, for whatever reason, you do this for five years and every year you either roll at the same strike (little additional "extrinsic cost" (silly term)) or you take some money out ... but the stock doesn't actually move back to $15 over those five years.

 

What have you accomplished? Well, you would've taken out the amount of cash roughly equivalent to the MTM losses that you're realising (if you make decisions perfectly), and you would've paid the cost for the time value of the option (what you call "extrinsic cost").

 

Is this better than buying one 5 year call (or doing a 5 year synthetic put)? It can be, but it may also not as it depends on the calls you make on each roll (right time, remaining TV you sell, volatility of the price, etc.).

 

 

 

 

 

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.

[Sunrider]

Since you deal in examples and analogues, perhaps this will serve to get my point across better (assuming you didn't get it in the past and simply chose to ignore it because there are these people that "don't get it" and argue "against" you).

 

You're basically like a guy going on a camping trip and comparing a bunch of apples with a bunch of non-radiated strawberries, solely on the basis that they are both fruit. You prefer strawberries so you take along those. You implicitly assume that you can buy new strawberries along the way somewhere in the wilderness (or pick them) since you are otherwise ignoring the fact that they will go off a lot faster than the apples.

 

That was the problem with your original argument in the BAC leverage spread, and hence I came back to it in one of my replies further up: Your conclusion is very simple: You will always choose the shorter term option (call or synthetic call) where you assume that the stock will move in your desired direction in a short amount of time. The cost of leverage stuff is just another way to express that (because of the way option pricing works). Implied in this (apart from the aforementioned assumption) is also the assumption that at least you will be no worse off if you are forced to roll. Thus, you are forced to take a view on the max time to roll and the trajectory of the price movement. Those are assumptions and the need for those are things you didn't acknowledge in the original discussion ... in fact, my memory may be hazy, I recall you being fairly dismissive to people that made that point.

 

Now, is it useful to look at a cost of a strategy? Absolutely.

Does your cost of leverage accomplish this? Absolutely.

Can you compare two strategies on this basis, absent other vital assumptions? Absolutely not!

 

Let's move on.

 

[Sunrider]

One thing that I would find interesting though is the question of what the optimal decision criterion here should be for instrument selection and roll decisions (in general terms ... as the actual decision would depend on the input assumptions such as probability of price going up, down or staying the same at each roll decision).

 

So for example, take another stock (to stay away from the emotionally charged BAC), TFSL at approximately 60% TBV (excl. MHC shares). I don't know when it will trade to book but since they are buying back shares as fast as they can there is some trajectory for this. The longest dated option is for July, so about 6 months out. A $12.5 put is about $0.3 with the stock at ~$14. You enter a synthetic long, the cost of that non recourse leverage (or more precisely leverage with a capped loss of $1.5) is (1+0.3/14)2 = ~4.3%. Dividend runs at 2.1% currently, so if one could ignore taxes, leverage would be financed at ~2.2%. Not bad.

 

Ok, so the stock can go up, down or stay the same (a trinomial tree). I haven't done this with an option pricing model (where you'd again have to make volatility assumptions along the way) but intuitively, it's probably worthwhile to look at the stock going down to exactly the strike as well.

 

So if we focus on the $12.5 and below range - this is what we know:

- PnL Put: $12.5 - stock price - $0.3

- PnL Stock: $14 - stock price

- PnL Combined (MTM and realised, at least at IB): $14- $12.5- $0.3 = $1.8

 

What is the right decision now? You can roll to the same strike, down to something lower or to a higher strike (or do nothing). Again, what do we know? (The following depends on market factors though, so for simplicity assume these stay the same, i.e. vol not increasing tremendously, etc.):

 

A) Roll to higher: We invest significantly more capital in the position. As the put is DITM, the cost for buying this protection is also significantly higher (e.g. another 6 month put for strike = $15 would be at least $15-stock price+ $0.2 ... so a fairly hefty annualised costs. This cost is of course locked in because if the stock increases, the put loses value at a similar rate (until it gets much closer to the strike, at which point one could recapture some of the premium ... but this requires yet another decision with a view on the future trajectory).

B) Roll to same: Assume $12.5 strike. So the premium and the cost will be less than in the above scenario.

C) Roll to lower: Assume, first, it's an at-the-money put. Premium will be elevated vs. second option, an OTM put. The latter would provide the cheapest cost for the non-recourse debt we implicitly take on (vis-a-vis the alternatives above, ceteris paribus)

 

Rolling to a higher option seems to not be a good choice. Rolling to the same strike basically leaves the investor in the same position as before. She only paid the cost of the initial option and the second option for this strategy and has taken the initial loss on the stock move ($1.8 above). However, this cost is increasing (the degree of which depends on how far that old strike is now above the stock price).

 

Rolling to a lower strike. The investor opens herself up to another loss, e.g. $2.5 if rolling down to $10. The benefit is a cheaper cost for non recourse debt. Is this worthwhile? Again one would have to make an assumption as to how much of that loss the investor will have to take (she cannot "wait it out" as the option forces her to recognise the loss at expiration). Let's compare the costs at either end of the extreme:

 

0. The cost for buying the $10 put, assuming a $12.5 stock might be in the region of $.2 - $.3 so cost approximately 0.25/14 ~3.6% p.a.

1. At a minimum this is a $0 loss (price above $12.5 original strike). Investor only pays 3.6% annualised

2. At a maximum this is a $2.5 loss (price below $10 new strike ... the implied cost basis is now $12.5 as the losses down to that point where recognised with the first expiration). Investor "pays" ($2.5 + $0.25)/14 ~43% annualised.

 

So, if the investor is agnostically pessimistic (yes, probably an oxymoron) then she may not want to end up in scenario 2 and therefore choose to not roll down. That cost for an ATM call may be ~$0.9, cost of that is 11%.

 

... long winded thought to work out the following: The investor can only make an "optimal" decision in the context of an assumed stock price by expiration, for she can only choose the "cheapest" option on every roll (rolling lower) if she is able to keep contributing capital. In other words, it all comes back to "How low do you think it can go?" If you're convinced that it can only go down to $7 (50% down, trading at ~30% TBV) then you can use this to size the position. Lever up so that you're not getting margin called on a loss of $7 x Number of synthetic calls x 100. If you want to be extremely conservative, assume that this happens on the first roll (as the costs of any rolls before the one that gets down to $7 add to the costs incurred).

 

Another question that should be asked in this strategy is which option expiry to choose? The near term one or the one further away?

-> Option further out has more TV, therefore is more expensive. Rationally (and ignoring trading costs), one should therefore use the nearest term option and roll persistently.

 

Eric, Mungerville - do you see this differently, or do you have any other/better heuristics to guide your decision-making?

 

Oh and one more thing - I think the above also demonstrates quite clearly that perhaps a longer term option is actually a more conservative choice (when faced with limited capital). It will be more expensive, but it does not force the frequent "recognition" of the MTM losses that is required at each expiry. Another way to illustrate this is to say that the theoretical max downside in this strategy is still the whole stock price ... i.e. one could end up rolling ever lower. Or, coming back to the original discussion: Choosing a short term vs. a long term call option is right iff you believe that the stock will rise sufficiently within the time frame of the shorter option. If you have to assume a number of rolls and you have a limit of how much capital you're able to contribute to the strategy, you may well be served better with the longer term option to begin with (and, of course, you pay for that extended optionality = extended time period someone lends you money with limited recourse).

 

 

[Guest Schwab711]

Thank you for putting in so much work Sunrider! When I first read Eric's explanation I knew it was wrong but I couldn't get a sufficient explanation to back up that feeling and I kept putting off the work needed. This is awesome that you have gone into detail explaining strategies with examples!

 

Just on definition of paying for volatility, options can be dangerous. I am not going to pretend to say that they have to be negative-EV but I'm glad you point out the number of assumptions you take on with each of the various bets. When markets only go up it's easy to think options are this under-appreciated gold mine but the other side of these trades is more-often sophisticated [institutional] investors than most other commonly purchased assets.

 

In all seriousness, why do people on this board invest in options? What is the rationale? Do any create spreadsheets of expected returns for various products with different assumptions? Do you solely focus on BS or are other factors considered? As Sunrider has asked, I'd be very interesting in hearing rationales. I wrote off options as an investment choice long ago so my knowledge of options could be plain wrong.

 

Probably predictable, but here's my thoughts on option investing:

 

I really can't see a situation where I'd be invested in anything but calls. Selling a put should probably be reserved for regulated companies to avoid expensive swans but if you really think it's such a good investment and you're trying to save a couple of bucks just buy the damn thing. The couple percent is never worth possibly missing the investment altogether if it really is so good (this assumes you're the type of investor that is the high batting average type).

 

Buying a put has always struck me as odd, just sell your position if you are worried about capital in the short term. You either shouldn't be investing at all or it's a hint that you should be in higher quality assets (you may be mis-judging your risk tolerance).

 

As to calls, selling them takes all the natural advantages of being long a cash-asset by capping returns. It can be a excellent option to increase returns on extremely safe, low-volatility investments when you think there will be little change in interest-rates expectations for some period of time (since this matters more than the actual rates for most investments. Throw in CCY XC and it's probably much more complicated than you assume). As you can guess, I'll probably never find a good situation to sell a covered/naked call.

 

Maybe surprisingly, buying calls can at times be a better investment choice than the underlying equity. I've been very tempted to purchased long-dated calls in the past and I'll likely allocate some percentage of my future equity investments into options as my portfolio grows. I also think I'd only consider long-term options (>6 months)as opposed to a shorter-term duration. If the LT option/warrant is not a better deal than just buy the underlying equity. If it is better, a lot needs to be considered. Without going into half the detail you have above, I would still generally stick with quality companies with stable, growing cash flows to keep your batting average high. If an option pays off at all you'll generally do fine so high batting average is probably more important than with common equity securities. LT warrants are also great because the American-style exercise option is worth significantly more than BS would predict if you stick with predictable underlying equity (since you'll be dealt numerous price-multiple prices throughout your holding period).

 

Situations like CLB, MCO (in 2012)  and many other quality companies who had significant short-term negative moves on potentially bad news can provide outstanding long-term returns (just look at Buffett's warrant purchases). Forget the punch card analogy, if you only buy options with as long of a term as possible when the highly specific criteria proposed above is met than you will likely have 50%+ long-term compounded returns, including the years of 0 txns! I'd be interested in any back-test papers on the topic. My quality-company criteria will likely make this difficult as I don't think the sample size should be much greater than a dozen or two over 10 years. Since only so much many can be put into these ideas due to volume vs MC and the short amount of time the opportunity presents itself, this is another investment strategy that highly favors smaller portfolios (<$50m but $100k - $10m is probably the sweet-spot).

 

 

I doubt anyone is too surprised on my feelings of options. Learning the nuances of horse racing from my Grandfather as a kid, he used to always say the best handicappers would make only a handful of 'real' bets over a year (real:= expectations of profiting, fun:= smaller entertainment bets; My grandpa liked horse racing more than stocks but he always said the same traits are required to profit!). When all the planets aligned just right it would take an act of god to prevent him from making a substantial bet no matter where the race was held. We have definitely made stops on the way to a wedding or dropping me off at the airport! Smaller investments in lower quality opportunities (not necessarily high/low quality company) are like the fun bets my grandpa would make with me. Like at a horse track, this only makes sense if you diversify your portfolio under the assumption that you are better than the average handicapper by a margin of at least the spread. If you want high [expected] returns, fewer, more concentrated bets with greater certainly is the only strategy that has legs in the long-run.

[Sunrider]

No problem. I just got tired, like some other members, of hearing the same stuff that, whilst not wrong, isn't right either. Assumptions matter and should be stated clearly. Contrary to other members who just resigned in the face of Eric's debating style I just felt the need to write it out.

 

Don't get me wrong, Eric made some great calls along the way (e.g. MBI) and he's benefitted tremendously by combining them with a leverage strategy. So I am always interested in hearing what he has to say about some stocks, I just want to make sure that others understand what the assumptions are that his leverage strategies depend on that, which he does not always state.

 

Anyway ... awfully quiet in this thread now. But that's probably good as I feel this horse has been flogged to death.

 

C.