Ask Eric!

[leadingusforward]

Eric -

 

If you don't mind me asking, what percentage of your capital is invested in GM?  Would this be any different if you had a smaller amount of capital?

 

Thanks in advance.

[ERICOPOLY]

Eric -

 

If you don't mind me asking, what percentage of your capital is invested in GM?  Would this be any different if you had a smaller amount of capital?

 

Thanks in advance.

 

I have a meaningful amount in GM -- the percentage is misleadingly low compared to where it would be if I didn't have money tied up in places where it is restricted.

 

But I still view my understanding of investing as rather amateurish and don't let my record mislead you to believe otherwise.  I first joined this board in 2004/2005 and asked a question about a company ACY that looked cheap based on assets, and the question was about some language that I couldn't even recognize as what one poster labeled as standard boilerplate poison pill.  Well, I felt intimidated and had to then watch ACY shares soar a blistering amount from the sidelines.  That's the only time I ever brought a completely new name to the board, and yet it was completely by accident.  After that, I've just compiled a record from standing back and waiting for a crowd to gather, and investing if it seemed obvious even to me.

 

I get the feeling that I would be tortured to death if Saddam were still around and was demanding that I articulate my GM thesis.  He would be cutting off my fingers in disbelief that somebody with such a record could be explaining his investment ideas like Forest Gump.

[yadayada]

Eric, Outerwall has a somewhat similar multiple as BAC had a few years ago. Somewhere between 3-5x multiple on the FCF they generate. Potentially 2x.

 

Would you pick the 2016 call options or the 2017 ones? They are buying back a lot of their own stock. Assuming FCF will stay stable here , if you play this with options, you probably look to take advantage of selling puts on shorter term? And buying leaps. So basicly trying to get more upside with leaps and then trying to get your money back with selling puts? And when stock is nearing fair value you start selling calls?

 

And you take volatility in account when selling puts? BAC is probably a lot less volatile then OUTR.

 

What sort of return would you look to get on selling puts then? for example you get about 1.5$ on writing 65$ jan 15 puts. So that is about a 18% annualized return then?

 

Im just trying to get a general idea of your strategy in laymans terms :) . I feel stupid reading half the posts in here.

 

No need to answer entire post in detail, if you got any general thoughts on those OUTR options (making above assumptions about company) would be much appreciated.

[ERICOPOLY]

Eric, Outerwall has a somewhat similar multiple as BAC had a few years ago. Somewhere between 3-5x multiple on the FCF they generate. Potentially 2x.

 

Would you pick the 2016 call options or the 2017 ones? They are buying back a lot of their own stock. Assuming FCF will stay stable here , if you play this with options, you probably look to take advantage of selling puts on shorter term? And buying leaps. So basicly trying to get more upside with leaps and then trying to get your money back with selling puts? And when stock is nearing fair value you start selling calls?

 

And you take volatility in account when selling puts? BAC is probably a lot less volatile then OUTR.

 

What sort of return would you look to get on selling puts then? for example you get about 1.5$ on writing 65$ jan 15 puts. So that is about a 18% annualized return then?

 

Im just trying to get a general idea of your strategy in laymans terms :) . I feel stupid reading half the posts in here.

 

No need to answer entire post in detail, if you got any general thoughts on those OUTR options (making above assumptions about company) would be much appreciated.

 

 

In layman's terms I'm using options to spread downside risk into multiple names while concentrating upside into perhaps only one or two.  The only reason for doing this is because of the obvious risk of concentrating the downside into one or two names.

 

Other people just choose to hold a basket of stocks in order to achieve downside diversification, but in doing so they forfeit upside concentration.

 

I'm in favor of getting upside concentration without the accompanying downside concentration, hence my approach.

[ERICOPOLY]

It's worth noting that if you are a better investor you can put together a basket of stocks with terrific upside and not mess around with options.

 

So you'll never see a Buffett or Munger messing around with this stuff.  I've used them as a crutch to cope with my pinpoint sized circle of competence.

[yadayada]

Ah ok, thanks. So what would your portfolio look like % whise? Let's say you got a 100k$, you need a margin account right? And you write puts on RWT, AXP, GE, LUK and WFC. And then buy calls on Fairfax? What $ size would you write those puts would you get? And how large would the call position be? The same size as the premiums from those puts?

 

Like 10k$ each for the puts, and then 50k$ on the Fairfax calls? Or is that too little in cash you are forced to buy them?

[ERICOPOLY]

Ah ok, thanks. So what would your portfolio look like % whise? Let's say you got a 100k$, you need a margin account right? And you write puts on RWT, AXP, GE, LUK and WFC. And then buy calls on Fairfax? What $ size would you write those puts would you get? And how large would the call position be? The same size as the premiums from those puts?

 

Like 10k$ each for the puts, and then 50k$ on the Fairfax calls? Or is that too little in cash you are forced to buy them?

 

All of those named had larger volatility premiums than FFH at the height of the 2009 panic.  It was possible to be 100% long FFH while only being 1/3 exposed to RWT, and effectively keeping 2/3 of your money completely risk-free in unencumbered cash.

 

That's not to say it's a good idea to do that.

 

However I think about these things critically with some amusement when people say they keep 20% in cash or others claim they don't keep cash.  Peering into their portfolios and looking at the options pricing could create for interesting debates.  What if one person is saying he is 100% invested and another claims to be prudently holding 67% cash... they argue back and forth, but perhaps you could reconstruct a portfolio equivalency using options.

[MG2014]

Hi Eric, I'm having problems posting from this computer, so hopefully this makes it.

 

I apologize for the long message in advance. I've been reading thru how you think about options and it's pretty interesting. Thanks for sharing your knowledge with us. I think I'm starting to understand your logic, but I just have a few questions

 

Conditions for the Strategy:

1) Company with overly depressed price

2) Will rise in price in a reasonable amount of time

3) Has a Liquid options market

(Any others?)

 

You chose 1.5x nonrecourse leverage, but why not as much as possible if your downside is being protected, does the implied cost of leverage becomes prohibitive?

Do you look at the normalized earnings yield + some safety margin for what cost of leverage you'll accept?

 

Apart from warrants, leaps, portfolio margin+puts, are there any other choices for non-recourse debt?

 

If I understood it right, you first used calls in the taxable and IRA accounts, but after opening a portfolio margin account, you chose common+portfolio margin+puts in the taxable account.

 

Reasons for switch:

instant liquidation policy in reg-t

portfolio margin looks at net exposure

Can't roll profitable call position without incurring taxes

you can roll puts along without taxable events.

won't lose dividend

Any others?

 

What impacts your decision to roll up the strike price to achieve 1.5x leverage again or to lever down by buying at the original strike price?

 

In your cost of leverage equation: (common-OptionPremium)(1+x)^t=strike*(1+div yield)^t.

I thought I saw somewhere that you add the cost of the put, not subtract? Could you clarify with an example?

 

Let's say the stock goes from $5 to $10 in 2 years.

At day 0, you find that the 2 year puts + portfolio margin is cheaper than warrants, so you go that route

At year 1, you find that the warrants are now cheaper; do you restructure to buy warrants instead?

I guess my question is how often would you look at the cost of leverage on the warrants vs puts and when would you consider switching? How would time decay affect this?

 

I think I finally understand the swapping risk part.

Leverage Chosen: 1.5x

Stock XYZ Common: 25

Stock XYZ Put @ 25 costing $2.5

BAC Common: 10

BAC Put @ 10 costing $1

 

1.5x Common + .5x Hedging Put financed by writing 0.2 XYZ Put. I'm getting .2 from $1*.5/$2.5

 

If you don't reinvest the .8 remaining from the XYZ put into more BAC common, Total downside = 100% downside from BAC + 20% downside from XYZ (Said differently 16.67% of the downside from XYZ and 83.3% from BAC)

 

If you reinvest the remaining .8 into more BAC common, Total downside = 130% downside from BAC + 20% downside from XYZ

 

Is this right?

 

The purpose of writing these puts is to limit single issue downside risk by diversifying the downside risk onto multiple names. How do you select those stocks? Do you look at volatility? Why'd you pick JPM and SHLD? What do you do if you get assigned the stocks? Immediately sell stock, start writing calls, hold and wait to recover? Why?

 

 

[leadingusforward]

 

He would be cutting off my fingers in disbelief that somebody with such a record could be explaining his investment ideas like Forest Gump.

 

That's what I admire about your investment approach.  Your theses are elegantly simple - like the perfect software coding solution.

 

What's the nightmare scenario that could cause a huge loss using portfolio margin protected by puts?  Just trying to better understand the risks.  It seems too good to be true.

 

Are there any books, articles or internet sites that you could recommend to get a better handle on options and portfolio margin?

 

 

[ERICOPOLY]

 

He would be cutting off my fingers in disbelief that somebody with such a record could be explaining his investment ideas like Forest Gump.

 

That's what I admire about your investment approach.  Your theses are elegantly simple - like the perfect software coding solution.

 

What's the nightmare scenario that could cause a huge loss using portfolio margin protected by puts?  Just trying to better understand the risks.  It seems too good to be true.

 

Are there any books, articles or internet sites that you could recommend to get a better handle on options and portfolio margin?

 

Real estate is similar -- non-recourse leverage doesn't mean you can't lose money.

 

I'm sure there are scenarios that involve my broker reducing margin limits or something, at an inconvenient time.  I'm aware it could happen.  I also sleep with my door open most of the year.  I figure I could recreate the position using calls and no margin, but the tax bill would be sobering.

[ERICOPOLY]

Hi Eric, I'm having problems posting from this computer, so hopefully this makes it.

 

I apologize for the long message in advance. I've been reading thru how you think about options and it's pretty interesting. Thanks for sharing your knowledge with us. I think I'm starting to understand your logic, but I just have a few questions

 

Conditions for the Strategy:

1) Company with overly depressed price

2) Will rise in price in a reasonable amount of time

3) Has a Liquid options market

(Any others?)

 

You chose 1.5x nonrecourse leverage, but why not as much as possible if your downside is being protected, does the implied cost of leverage becomes prohibitive?

Do you look at the normalized earnings yield + some safety margin for what cost of leverage you'll accept?

 

Apart from warrants, leaps, portfolio margin+puts, are there any other choices for non-recourse debt?

 

If I understood it right, you first used calls in the taxable and IRA accounts, but after opening a portfolio margin account, you chose common+portfolio margin+puts in the taxable account.

 

Reasons for switch:

instant liquidation policy in reg-t

portfolio margin looks at net exposure

Can't roll profitable call position without incurring taxes

you can roll puts along without taxable events.

won't lose dividend

Any others?

 

What impacts your decision to roll up the strike price to achieve 1.5x leverage again or to lever down by buying at the original strike price?

 

In your cost of leverage equation: (common-OptionPremium)(1+x)^t=strike*(1+div yield)^t.

I thought I saw somewhere that you add the cost of the put, not subtract? Could you clarify with an example?

 

Let's say the stock goes from $5 to $10 in 2 years.

At day 0, you find that the 2 year puts + portfolio margin is cheaper than warrants, so you go that route

At year 1, you find that the warrants are now cheaper; do you restructure to buy warrants instead?

I guess my question is how often would you look at the cost of leverage on the warrants vs puts and when would you consider switching? How would time decay affect this?

 

I think I finally understand the swapping risk part.

Leverage Chosen: 1.5x

Stock XYZ Common: 25

Stock XYZ Put @ 25 costing $2.5

BAC Common: 10

BAC Put @ 10 costing $1

 

1.5x Common + .5x Hedging Put financed by writing 0.2 XYZ Put. I'm getting .2 from $1*.5/$2.5

 

If you don't reinvest the .8 remaining from the XYZ put into more BAC common, Total downside = 100% downside from BAC + 20% downside from XYZ (Said differently 16.67% of the downside from XYZ and 83.3% from BAC)

 

If you reinvest the remaining .8 into more BAC common, Total downside = 130% downside from BAC + 20% downside from XYZ

 

Is this right?

 

The purpose of writing these puts is to limit single issue downside risk by diversifying the downside risk onto multiple names. How do you select those stocks? Do you look at volatility? Why'd you pick JPM and SHLD? What do you do if you get assigned the stocks? Immediately sell stock, start writing calls, hold and wait to recover? Why?

 

There are a lot of questions here.  I don't think I operate with any disciplined measure of precision.  I just got myself into the fight and started accumulating kills.  To continue the Forrest Gump  analogy, "I just started running."

[MG2014]

There are a lot of questions here.  I don't think I operate with any disciplined measure of precision.  I just got myself into the fight and started accumulating kills.  To continue the Forrest Gump  analogy, "I just started running."

 

"Yes, drill sergeant!"

 

If I had to choose one, it would be the one about swapping downside risk. Could you comment on that?

 

Just trying to better understand the nuances of this strategy. I don't want it to bite me "right in the buttocks" if I see an opportunity to use it one day.

[ERICOPOLY]

There are a lot of questions here.  I don't think I operate with any disciplined measure of precision.  I just got myself into the fight and started accumulating kills.  To continue the Forrest Gump  analogy, "I just started running."

 

"Yes, drill sergeant!"

 

If I had to choose one, it would be the one about swapping downside risk. Could you comment on that?

 

Just trying to better understand the nuances of this strategy. I don't want it to bite me "right in the buttocks" if I see an opportunity to use it one day.

 

Buy a put to hedge one of your positions.

Write a put on a stock where you have no position.

 

You've swapped risk.  It's a diversification technique.

[MG2014]

What would you do if you get assigned the underlying?

 

I don't think I operate with any disciplined measure of precision

 

To this point, I think you're being a too modest. Writing a script to compare returns on a margin leveraged stock to those on a warrant doesn't exactly scream imprecision to me. More so a calculated, prudent investor.  :)

[ERICOPOLY]

What would you do if you get assigned the underlying?

 

 

Well, perhaps sell for tax loss.  Perhaps hold for future appreciation.  Perhaps sell covered calls.

 

Maybe curse and spit a little.  Kick the dog.

[moody202]

In layman's terms I'm using options to spread downside risk into multiple names while concentrating upside into perhaps only one or two. 

 

Are you able to share your thought process for selecting companies for spreading downside risk? I am assuming they are not generally in the same industry, curious to know how you go about shortlisting them?

[ERICOPOLY]

In layman's terms I'm using options to spread downside risk into multiple names while concentrating upside into perhaps only one or two. 

 

Are you able to share your thought process for selecting companies for spreading downside risk? I am assuming they are not generally in the same industry, curious to know how you go about shortlisting them?

 

Not much process to be shared.  I really don't think you guys really understand how little I know.  Remember in the Wizard of Oz where this little man with a gentle voice steps out from behind the curtain?  Well, it's sort of like that.

[ERICOPOLY]

 

He would be cutting off my fingers in disbelief that somebody with such a record could be explaining his investment ideas like Forest Gump.

 

That's what I admire about your investment approach.  Your theses are elegantly simple

 

Simple is as simple does.  Can't that be true?

[Liberty]

The less humble way to say it is that most of us have to invest using processes to guide us and keep us from falling off the rails, and Eric invests by sheer raw brainpower. That's how he periodically distills down all these potential ideas that flow through the forum/news into a few bankable insights that he bets big on, structuring the bets so they're as asymmetric and tax efficient as possible.

 

The man behind the curtain might have seemed unimpressive at a glance, but dammit, he still found a way to actually run Oz, something that the story doesn't give him enough credit for ;)

 

Yeah, I know, it's embarassing how I sing your praises. Sorry about that, Eric, but I suspect my take is correct and nobody falling anywhere outside of the rightmost part of the bell curve could do what you do, despite anything you might say about not knowing much.

[ERICOPOLY]

I think if I really believed in my abilities, I would start picking out my own original investment ideas and very quickly lose money.  So stop trying to sabotage my system.  I don't know anything, I'm here to cheat off of others if enough gurus like the idea... and when even I can understand it... because it's actually obvious enough for me to understand.

[muscleman]

I think if I really believed in my abilities, I would start picking out my own original investment ideas and very quickly lose money.  So stop trying to sabotage my system.  I don't know anything, I'm here to cheat off of others if enough gurus like the idea... and when even I can understand it... because it's actually obvious enough for me to understand.

 

So if you bet big on something and it didn't work out well, and less people started to like the ideas, what would you do?

[ERICOPOLY]

I think if I really believed in my abilities, I would start picking out my own original investment ideas and very quickly lose money.  So stop trying to sabotage my system.  I don't know anything, I'm here to cheat off of others if enough gurus like the idea... and when even I can understand it... because it's actually obvious enough for me to understand.

 

So if you bet big on something and it didn't work out well, and less people started to like the ideas, what would you do?

 

Worry.  Maybe sell.  Depends.

[AtlCDore]

I think if I really believed in my abilities, I would start picking out my own original investment ideas and very quickly lose money.  So stop trying to sabotage my system.  I don't know anything, I'm here to cheat off of others if enough gurus like the idea... and when even I can understand it... because it's actually obvious enough for me to understand.

 

Eric,

 

With that humble and self-effacing attitude, how do you ever expect to raise a $1 Billion fund from institutional investors?! 

 

They would rather have their fund managers show marginal returns with very little volatility who can pontificate about everything than someone like yourself who shoots the lights out but claims he can't find his own investments and poaches his ideas off of others. 

 

Oh, the insanity!

 

Best,

 

AtlCDore

[Liberty]

I think if I really believed in my abilities, I would start picking out my own original investment ideas and very quickly lose money.  So stop trying to sabotage my system.  I don't know anything, I'm here to cheat off of others if enough gurus like the idea... and when even I can understand it... because it's actually obvious enough for me to understand.

 

I believe you when you say that you find your ideas from others (especially when multiple names you trust jump in) and that you have no edge on most things. But if one definition of intelligence is "the ability to reach your goals", then knowing your own strengths and weaknesses and doing things in such a way that results are maximized is quite consistent with this. The proof's in the pudding; a zillion people are trying to copy Buffett and Berkowitz, yet how many have compounded at 70% CAGR for a decade or whatever it is?

 

Most people in your situation would probably get a first big success, get a big head, think they can do anything (shoe button complex), and then crash and burn. I think that what hasn't happened over the years is as much a testament to your discipline as anything that did happen.

 

Anyway, I know this armchair psychoanalysis is in bad taste, so I'll stop now :)

[Hawks]

+1 re your reply #194