Huge amounts of non-recourse leverage possible?

[ERICOPOLY]

Here:

http://www.cornerofberkshireandfairfax.ca/forum/strategies/bac-leverage/msg245797/#msg245797

 

and

 

It was talked about a bit here:

http://www.cornerofberkshireandfairfax.ca/forum/strategies/warrants-for-leveraged-garp-investing/50/

 

It's all strung out because it generated a lot of questions and doubts.

 

Thanks for posting and writing this Eric.

 

The more I think about it, long term call Leaps are probably one of the best way to achieve this.  Long with puts could be similar. 

Options pricing does not take fundamental values into account and therefore on a long term basis this can be the inefficiency.

 

To get really great odds though I think 2 things have to be present.

1.  Extreme undervaluation

2.  Low cost of the option premium. 

 

The upside is magnified returns vs unlevered long only.

 

Downside is getting wiped out if the stock is down.

 

So to be 100% invested in calls has wipeout risk.

 

Yes, 100% invested in calls has wipeout risk. 

 

The 2006 FFH trade was to buy the calls in May/June and to deleverage after the hurricane season passed.  Hurricane seasons don't last past November and the 2008 calls didn't expire for yet another 14 months after that.

 

The theory was that their extrinsic value was artificially low due to the crowded short trade with short sellers using the options market maker exemption because there were not enough physical shares to borrow.  Additionally, the time value component of the extrinsic value decays relatively slowly so this was the safest window of the holding period.

 

 

[cashisking]

Sell long dated in the money puts (on companies you expect to increase in value) and calls (on etfs and companies expected to decrease in value). Use that to buy long dated warrants - ones where the implicit cost of borrowing is low. Look for warrants that just start to trade - some experience a spin off effect and get dumped. Post reorg warrants are the sweet spot IMO - all the benefits of post reorg valuation, fresh start accounting etc for the underlying company, and the holders are usually former retail equity holders and debt holders (neither are too interested in holding the warrants that represent pennies on the dollar of their original capital)...

 

For selling naked puts and calls you are going to need margin. In canada we have TFSA account types (similar to Roth IRA in US) and Questrade has a feature that allows you to use your tfsa assets as collateral for your margin account at no cost. So there is no cash cost for borrowing the margin needed to hold short option positions if you set it up that way.

 

I guess buying CEFs at a discount to NAV is a form of borrowing. You get the discount at no cost and its non recourse to you. The discount can multiply if the CEF holds assets that themselves are discounted (I'm thinking of a bond CEF at a discount and the underlying bonds are trading at a discount to par for some technical reason).

[bizaro86]

Another potential way to add a bunch of leverage is through split shares. Basically, these are retail yield pig vehicles. They start with a $25 NAV, split between a $10 preferred share and a $15 common share. The prefs get a preferred dividend, and the common gets a levered play on the underlying portfolio. They tend to overdistribute on the common, so the NAV often decreases. But that just makes them even more levered.

 

As an example: TSX:FFN is a portfolio of 15 US/Canadian financials. Largest positions are BofA, JPM, WFC, and GS (in order) so potentially attractive valuations.

 

The NAV in total is ~$16, so the NAV to the common is ~$6. The common trades at $6.26 CAD, so you're paying something for the leverage. They distribute $1.20 to the common per year (until they bottom out at whatever the NAV minimum is). This is close to 3 to 1 leverage on a diversified portfolio of financials at relatively low cost.