Using Deep In the Money Calls as Non-Recourse Leverage

[cameronfen]

I know this applies only to a minority of firms and its rarer now with things being bubbly.  However, I was wondering how to correct for bad asset allocation, especially in the tech sector where I mostly invest.  One thing I noticed is a lot of tech firms don't issue enough debt.  Now I can't stop firms from more secondary offerings, but I can simulate a more leveraged company by buying (usually deep) in the money call options with as long-dated as possible as that's how to get the most favorable "interest rate".  This doesn't change the enterprise values but simulates change the capital structure to have debt equal to current net debt+(strike price)/(current price)*(market cap).  And so you can effectively increase the leverage of the capital structure.    The interest rate then is the premium you pay above the current price factoring at your strike price.  Divide that by the time to expiration and divide by the strike price and you have an effective "interest rate" you are paying on that debt.  Notice how the call option is non-recourse debt and so it is better than just using a margin account.  This is the main reason why I would use this and I would never touch leverage even if I had to pay a higher "interest rate".  I am reminded of something Sam Zell said (I think it was him) about how succeeding in real estate involves buying undervalued properties with appropriate use of non-recourse debt.  I'm curious if anyone had any thoughts on this strategy (if I did the math right as well), and if people could think of some stocks that are undervalued in an EV basis but have not enough debt.  I think FB may be one candidate, as is CMSCA if you believe John Malone.  Maybe some REITs that are under-leveraged as well but again in this economy everything is probably over-leveraged. 

[SharperDingaan]

Be very careful that you FULLY understand what you're proposing here, as you're trying to do a version of gamma trading.

http://www.volcube.com/resources/options-articles/what-is-gamma-trading/

 

What about the time decay cost? and the continuous change in delta as time decays?

Did you recognize that 'roll-over' costs are commission, PLUS the difference in strike price on the new vs old option?

Where's the ongoing cashflow coming from to pay for all this?

 

Versus - just buying a LEAP, warrant, or doing a straight-forward convertible/debt arbitrage.

And betting on the direction of the industry (via an index, ETF, etc), rather than individual companies within it?

 

SD

 

 

 

 

[cameronfen]

Be very careful that you FULLY understand what you're proposing here, as you're trying to do a version of gamma trading.

http://www.volcube.com/resources/options-articles/what-is-gamma-trading/

 

What about the time decay cost? and the continuous change in delta as time decays?

Did you recognize that 'roll-over' costs are commission, PLUS the difference in strike price on the new vs old option?

Where's the ongoing cashflow coming from to pay for all this?

 

Versus - just buying a LEAP, warrant, or doing a straight-forward convertible/debt arbitrage.

And betting on the direction of the industry (via an index, ETF, etc), rather than individual companies within it?

 

SD

 

Wait all this strategy is is buying a LEAP/warrant call option deep in the money.  The time delay cost assuming the market doesnt move is the interest rate.  I would only roll over if the interest rate on the next option is reasonable for the leverage i would take.  I havent thought about comissions really, I'll have to factor that in.  The point is its non-recourse which makes it more attractive then margin debt. 

[bizaro86]

 

Wait all this strategy is is buying a LEAP/warrant call option deep in the money.  The time delay cost assuming the market doesnt move is the interest rate.  I would only roll over if the interest rate on the next option is reasonable for the leverage i would take.  I havent thought about comissions really, I'll have to factor that in.  The point is its non-recourse which makes it more attractive then margin debt.

 

This has been discussed at length on this forum. Check for posts by Ericopoly about BAC and FFH for a long and specific example of how this worked (very well).

 

IIRC he eventually switched to using portfolio margin to buy long stock along with purchasing puts.

[LC]

As bizaro said I think the most effective method (for tax purposes IIRC) is to purchase stock on margin and protection via puts.

 

The most important thing is to do a solid analysis up front taking into account all scenarios and tax situations, and see how the P&L behaves

[cameronfen]

 

Wait all this strategy is is buying a LEAP/warrant call option deep in the money.  The time delay cost assuming the market doesnt move is the interest rate.  I would only roll over if the interest rate on the next option is reasonable for the leverage i would take.  I havent thought about comissions really, I'll have to factor that in.  The point is its non-recourse which makes it more attractive then margin debt.

 

This has been discussed at length on this forum. Check for posts by Ericopoly about BAC and FFH for a long and specific example of how this worked (very well).

 

IIRC he eventually switched to using portfolio margin to buy long stock along with purchasing puts.

 

Thanks to both you and LC.  I will look into. 

[LC]

You can wade through the BAC thread but I think there is a more concise thread in the Strategies section, but I am having a hard time locating it. Best bet would be to check Eric's post history and try to narrow down where it was discussed.

[DooDiligence]

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/huge-amounts-of-non-recourse-leverage-possible/msg354290/#msg354290