BAC leverage

[Mephistopheles]

Great discussion here. Thanks Eric for being so patient in explaining all of this. I understand the 13% # and why it would be much profitable to borrow money at low rates to buy BAC rather than own the warrants. But many of us on this board believe that BAC will be worth more than $25 in 2019. Let's assume that will happen. Isn't the bottom line then that the warrant will outperform the stock? I understand what you're saying that the cost of leverage should get cheaper, and therefore the stock will outperform the warrant (I assume you mean in the short run), but in the long run the warrant will still outperform vs. the common, even if the leverage gets cheaper for a while, as long as BAC crosses $25. So then we should assume that everything is better than owning the common: whether it's the warrant, options, or borrowing on margin. Then it's just a question of what is the best and worst, and you're saying that the warrants are the worst out of the 3 ways to lever (even though all 3 are better than the common), right?

[ERICOPOLY]

Then it's just a question of what is the best and worst, and you're saying that the warrants are the worst out of the 3 ways to lever (even though all 3 are better than the common), right?

 

Yes, that's all I'm saying -- shop around for the cheapest cost of leverage.  Just like when you look for a home mortgage, you shop for a lower rate.

 

[Investmentacct]

Hi Eric,

 

Do you have preference over buying between 10$ strike vs 12$ strike on leaps jan 15? If, so please explain.

 

Thanks and rgds.

[Sunrider]

Sorry Eric et al

 

Maybe I'm daft or it's just the end of a long day at the end of a long week.

 

Eric - your example in summary is basically: take a sum of money that pays for one share and invest (scenario A) OR scenario B, take the same amount of money, buy one warrant and be left with 6.35 or so in cash. Then ask yourself what the cash would have to earn to get you to a breakeven holding the warrant (i.e. 13.3), this return is your 13% that you then label as the implied cost of leverage. Right so far?

 

So, if we instead take the money, buy one option, for arguments sake a 2015 12 call at 2.3, then we're left with 9.7 (assuming shares trading at 12). Again, ask what the breakeven price would have to be and what rate this implies on the cash. BE = 14.3; Rate = (14.3/9.7)-1 = 47%, equating to about 24% annualised.

 

So in this example (and granted the 2.3 option price at 12 share price may be not entirely accurate) we'd see a higher implied cost for the the LEAPS.

 

Where am I missing what you're saying?

 

Thank you - C.

 

[hyten1]

sunrider

 

your 2015 12 call example should be this

 

12 - 2.3 = 9.7

 

breakeven is you need to grow 9.7 to 12, not 14.3

 

because breakeven is 14.3, you have 2.3 + 12 = 14.3, 2.3 you already have, the 12 you need to get it from compounding the 9.7

 

hy

[hyten1]

eric

 

also the thing with comparing leaps with the warrant

 

since just today the common/leap have gone up more than the warrant

 

the common vs warrant comparison keeps changing depending on the current price for both :)

 

at some point if the current trend continues warrant will become more advantages... i think?

 

 

hy

[Sunrider]

sunrider

 

your 2015 12 call example should be this

 

12 - 2.3 = 9.7

 

breakeven is you need to grow 9.7 to 12, not 14.3

 

because breakeven is 14.3, you have 2.3 + 12 = 14.3, 2.3 you already have, the 12 you need to get it from compounding the 9.7

 

hy

 

Gotcha - thanks. So the calc basically reduces to the point that a longer term option costs more and, further, that the delta in price of the options (or, here, option to warrant) may not be proportionally the same as a straight forward TVM calculation may imply (i.e. the interest rate needed to make up for the higher warrant price in Eric's example is somewhat higher than what we would expect if we simply took the rate we need for the option calculation and applied it to not just 1 year, 9 months but to 6 years).

 

Right?

 

If so, then we've effectively just re-discovered another way to describe that the IV in the warrants is higher than IV of the options ... which perhaps makes sense in that maybe the market assumes more can happen in 6 years than 1 year and 9 months. (Whether one agrees on this being sensible - see Buffet's point on LT put options or not). Or, alternatively, it may simply be that there are more people trying to buy the warrants than there are sellers and the price (and consequently IV) remain elevated vis-a-vis a comparable (here the LEAPS).

 

Makes sense.

 

Either way - I agree that given X, using options gives the 'cheapest' leverage (or the most leverage) and I wouldn't expect any sort of 'arbitrage' to arise here (also vis-a-vis dividends). The difference we see is what the market gives us due to supply/demand in the warrants.

 

What I need to mull over for a bit is the risk involved here. If I take USD x and put it into options vs. putting it into warrants then I need to assume that the stock price will be above strike + cost for me not to have an issue at the time of roll. Worst case the option goes to zero or a substantial loss. So it all comes back to an assumption about where the price will be AND by when. I suppose that's why this whole conversation confused me initially because I couldn't see how we can make these statements without assuming at least something about the price at the chose horizon (here the LEAP expiry to make it comparable). Looked at it this way, it will always be the case, I think (need to think more), that the longer term option appears 'more expensive' on the assumption of a certain price by the expiration date ... because it has some optionality left by the date of shorter-term option's expiration.

 

So the choice then is about how much time we feel comfortable with ...

 

Cheers - C.

[ERICOPOLY]

 

What I need to mull over for a bit is the risk involved here. If I take USD x and put it into options vs. putting it into warrants then I need to assume that the stock price will be above strike + cost for me not to have an issue at the time of roll. Worst case the option goes to zero or a substantial loss. So it all comes back to an assumption about where the price will be AND by when. I suppose that's why this whole conversation confused me initially because I couldn't see how we can make these statements without assuming at least something about the price at the chose horizon (here the LEAP expiry to make it comparable). Looked at it this way, it will always be the case, I think (need to think more), that the longer term option appears 'more expensive' on the assumption of a certain price by the expiration date ... because it has some optionality left by the date of shorter-term option's expiration.

 

So the choice then is about how much time we feel comfortable with ...

 

Cheers - C.

 

Stock price is zero a year from today because world financial system collapses. Lose $2 from the LEAPS or lose $5.50 from the warrants.

 

Which strategy is riskier again? 

 

The LEAPS are cheaper besides, so lower cost as well as lower downside.

 

 

 

 

 

 

[Sunrider]

 

What I need to mull over for a bit is the risk involved here. If I take USD x and put it into options vs. putting it into warrants then I need to assume that the stock price will be above strike + cost for me not to have an issue at the time of roll. Worst case the option goes to zero or a substantial loss. So it all comes back to an assumption about where the price will be AND by when. I suppose that's why this whole conversation confused me initially because I couldn't see how we can make these statements without assuming at least something about the price at the chose horizon (here the LEAP expiry to make it comparable). Looked at it this way, it will always be the case, I think (need to think more), that the longer term option appears 'more expensive' on the assumption of a certain price by the expiration date ... because it has some optionality left by the date of shorter-term option's expiration.

 

So the choice then is about how much time we feel comfortable with ...

 

Cheers - C.

 

Stock price is zero a year from today because world financial system collapses. Lose $2 from the LEAPS or lose $5.50 from the warrants.

 

Which strategy is riskier again? 

 

The LEAPS are cheaper besides, so lower cost as well as lower downside.

 

Hi Eric

 

Note that I said "given X" ... so given X USD - which is the basis of what your argument. I.e. you're starting by saying 'take 12 dollars invest it in BAC" or "take 12 dollars and invest it in a Leap ..."

 

So in both the LEAP and the warrant scenario the X will be gone - it's NOT about losing 2 on the LEAP or 5 on the warrant. You'll lose X dollars. Again, I'd have to mull this over a bit but I think structurally from your argument it will always have to come back to this. That is, you will have to make an assumption about a price by some expiration date and, further, you will have to assume that you are investing a fixed sum for which you wish to gain the maximum (i.e. cheapest) leverage.

 

Don't get me wrong, I'm not trying to dismiss your thinking or devalue your posts! I'd like someone to challenge me but at this point it seems to me that in all of these examples one has to assume that BAC rises over the minimum (i.e. shortest) time horizon (i.e. what ever the time to expiration is for the shortest comparable) - otherwise one risks to end up being caught out when the tide goes out.

 

That conclusion in itself doesn't surprise me too much - I would've very much liked you to have found something different/novel that would've allowed us to make a better/safer/bigger profit ;-) !!! ...  but at the end of the day this can't be in a (reasonably) efficient market. The only thing we can exploit here is the the markets (hopefully) mis-assessment of BAC's ability to turn itself into a >10% RoE firm. What we cannot control is how the market prices BAC at any given point. Whether one believes that it will be meaningfully above strike by expiration for a LEAP or whether one feels that one would rather have some further time for things to work out, everybody has to decide for themselves.

 

So again, no intention to dismiss any of your work here - just wanted to see if someone can come up with something that can obviate the need for having a certain price by a - relatively - close date.

 

Cheers - C.

 

P.S. Long BAC, LEAPS and Warrants in very meaningful amounts (well, for my account size).

[ERICOPOLY]

eric

 

also the thing with comparing leaps with the warrant

 

since just today the common/leap have gone up more than the warrant

 

the common vs warrant comparison keeps changing depending on the current price for both :)

 

at some point if the current trend continues warrant will become more advantages... i think?

 

 

hy

 

I believe when the stock gets near 1.5x tangible book value and trades at P/E of 10x, the leverage in the warrant will be a lot cheaper than 10% annualized.  The $13.30 put will be worth very little to people, and they won't pay you very much for it.

 

So that's when I might buy it again. 

 

[Sunrider]

 

What I need to mull over for a bit is the risk involved here. If I take USD x and put it into options vs. putting it into warrants then I need to assume that the stock price will be above strike + cost for me not to have an issue at the time of roll. Worst case the option goes to zero or a substantial loss. So it all comes back to an assumption about where the price will be AND by when. I suppose that's why this whole conversation confused me initially because I couldn't see how we can make these statements without assuming at least something about the price at the chose horizon (here the LEAP expiry to make it comparable). Looked at it this way, it will always be the case, I think (need to think more), that the longer term option appears 'more expensive' on the assumption of a certain price by the expiration date ... because it has some optionality left by the date of shorter-term option's expiration.

 

So the choice then is about how much time we feel comfortable with ...

 

Cheers - C.

 

Stock price is zero a year from today because world financial system collapses. Lose $2 from the LEAPS or lose $5.50 from the warrants.

 

Which strategy is riskier again? 

 

The LEAPS are cheaper besides, so lower cost as well as lower downside.

 

Hi Eric

 

Note that I said "given X" ... so given X USD - which is the basis of what your argument. I.e. you're starting by saying 'take 12 dollars invest it in BAC" or "take 12 dollars and invest it in a Leap ..."

 

So in both the LEAP and the warrant scenario the X will be gone - it's NOT about losing 2 on the LEAP or 5 on the warrant. You'll lose X dollars. Again, I'd have to mull this over a bit but I think structurally from your argument it will always have to come back to this. That is, you will have to make an assumption about a price by some expiration date and, further, you will have to assume that you are investing a fixed sum for which you wish to gain the maximum (i.e. cheapest) leverage.

 

Don't get me wrong, I'm not trying to dismiss your thinking or devalue your posts! I'd like someone to challenge me but at this point it seems to me that in all of these examples one has to assume that BAC rises over the minimum (i.e. shortest) time horizon (i.e. what ever the time to expiration is for the shortest comparable) - otherwise one risks to end up being caught out when the tide goes out.

 

That conclusion in itself doesn't surprise me too much - I would've very much liked you to have found something different/novel that would've allowed us to make a better/safer/bigger profit ;-) !!! ...  but at the end of the day this can't be in a (reasonably) efficient market. The only thing we can exploit here is the the markets (hopefully) mis-assessment of BAC's ability to turn itself into a >10% RoE firm. What we cannot control is how the market prices BAC at any given point. Whether one believes that it will be meaningfully above strike by expiration for a LEAP or whether one feels that one would rather have some further time for things to work out, everybody has to decide for themselves.

 

So again, no intention to dismiss any of your work here - just wanted to see if someone can come up with something that can obviate the need for having a certain price by a - relatively - close date.

 

Cheers - C.

 

P.S. Long BAC, LEAPS and Warrants in very meaningful amounts (well, for my account size).

 

... and , sorry to add to this, whether one is willing to pay a premium for this long time period that is not a linear extrapolation of the premium for the shorter (LEAPS) premium ... is what everyone needs to decide according to their comfort level.

[ERICOPOLY]

Hi Eric

 

Note that I said "given X" ... so given X USD - which is the basis of what your argument. I.e. you're starting by saying 'take 12 dollars invest it in BAC" or "take 12 dollars and invest it in a Leap ..."

 

So in both the LEAP and the warrant scenario the X will be gone - it's NOT about losing 2 on the LEAP or 5 on the warrant. You'll lose X dollars. Again, I'd have to mull this over a bit but I think structurally from your argument it will always have to come back to this. That is, you will have to make an assumption about a price by some expiration date and, further, you will have to assume that you are investing a fixed sum for which you wish to gain the maximum (i.e. cheapest) leverage.

 

 

Then you've completely misunderstood me.

 

Look, if you invest $12 in the warrant at $5.50 per warrant, then you have 2.18x leverage.  You own upside on 2.18 shares of common.

 

I'm simply saying that to purchase 2.18x leverage it's far cheaper leverage to go with the LEAPS.  Or go with a mixture of common+at-the-money LEAPS until you have 2.18x leverage of upside (equivalent to owning the upside on 2.18 shares of common).

 

I'm not saying go put the entire $12 into the LEAPS right now for 6x leverage with the 2-year LEAPS when the stock is priced at $12.  I'm not an effing idiot  ;D  That would be completely insane!

 

 

[Hielko]

Have to say that reading a big thread on leverage in a value investing forum is fascinating. Especially since I get a - no offence -a strong "in the land of the blind, the one-eyed man is king" feeling here. Sure, the Black-Scholes option pricing model does have it's flaws, and is not suitable to value warrants that have a long time to go before they reach maturity, but that doesn't mean that it doesn't tell you anything and that there aren't alternative models. Stuff like theta decay and the term structure of volatility do matter. You absolutely cannot easily compare options with different strikes and maturities and say what's cheap or expensive!

 

What basically determines the value of an option are all possible paths the share price can take between now and maturity, and the individual probability of every path. That's not something that you can easily translate when you are taking about different maturities and strikes.

[ERICOPOLY]

What basically determines the value of an option are all possible paths the share price can take between now and maturity, and the individual probability of every path. That's not something that you can easily translate when you are taking about different maturities and strikes.

 

That's a trader's mentality.

 

The businessman's mentality is to keep the eyes wide open:

1)  we are using leverage here, no fooling around

2)  let's keep the costs down for the leverage

 

You don't get to that level of thinking if all you worry about is theta decay, black scholes, etc...

 

Think in terms of... what if the market shuts down and I'm forced to hold (not trade this thing)?  How much value am I getting versus what I'm giving?

 

And that's what I am doing.  I am breaking down all the fancy Wall Street lingo and asking the most important of questions:  "am I prepared to be in this option until the end, and is it a worthwhile cost of leverage"?

 

Or if you were an athlete, let's use a track and field analogy:

Do you want to run around a racetrace with 8 ft hurdles or 13 ft hurdles?  Think of the annual cost of leverage as the height of the hurdles.

 

[Hielko]

I disagree completely, and this has nothing to do with 'a traders mentality'.

 

You might be willing to hold the LEAP till maturity in 2015, but what's the value of the warrants at that point? You can't compare the 'cost of leverage' if you have no idea how valuable the warrant will be at that point in time. Or you might decide to buy new LEAPs, but how expensive will be rolling your position? You can't know that if you have no assumption on how the distribution of possible shares prices will look like and the probability of the various implied volatilities at that point in time.

 

What you are doing is making a comparison that makes absolutely no sense, sorry.

[ERICOPOLY]

I disagree completely, and this has nothing to do with 'a traders mentality'.

 

You might be willing to hold the LEAP till maturity in 2015, but what's the value of the warrants at that point?

 

Who gives a shit, honestly, what the LEAP is worth in two years?

 

It's value is the non-recourse leverage on an asset at 10% interest rate.

 

Suppose I instead take out a 10% loan to finance BAC?

 

What the value of the sunk-cost of my monthly interest payments in 2 years?

 

It's called, an "interest expense" on balance sheets.  Here, it's prepaid interest.

 

EDIT:  I meant to say it's "interest expense" on income statements, but it's "prepaid interest" on my fictional balance sheet.  It amortizes at varying rates from time to time based on passage of time and implied volatility, but I'm not a trader -- that doesn't matter to me.  I'm using it for financing the leverage of the asset -- not to make money timing when Black Scholes volatility goes up or down.

 

[Hielko]

But you don't know how much the cost of leverage is for a two year period if you use the warrants, because the costs depends on what happens with the share price, implied volatility, theta decay and all those 'academic things'. So how can you claim the X is cheaper than Y if you don't know the cost of X?

[ERICOPOLY]

But you don't know how much the cost of leverage is for a two year period if you use the warrants, because the costs depends on what happens with the share price, implied volatility, theta decay and all those 'academic things'. So how can you claim the X is cheaper than Y if you don't know the cost of X?

 

Let's stop pretending that we all aren't in this for a rising stock price.

 

Raise of hands, can anyone tell me what happens to a put option price as the common stock skyrockets?

 

 

[valueinvesting101]

So what is THE strategy that you went with Eric?

Buying common and LEAPs expiring in 2015 at strike 10 & 12? Did you buy put or you will buy them when they will be cheaper when stock has moved up higher?

 

May be it is already answered already but I read discussion on this board few times but I have only understood parts of it.

 

[Hielko]

But you don't know how much the cost of leverage is for a two year period if you use the warrants, because the costs depends on what happens with the share price, implied volatility, theta decay and all those 'academic things'. So how can you claim the X is cheaper than Y if you don't know the cost of X?

 

Let's stop pretending that we all aren't in this for a rising stock price.

 

Raise of hands, can anyone tell me what happens to a put option price as the common stock skyrockets?

I'm not the one who started a huge thread on how X is better than Y... The stock price going up is obviously good news for both leaps and warrants, but doesn't change the fact that this whole thread is mostly nonsense.

[meiroy]

Time to start a dead pool for some of the posters on this thread.

 

Look who's talking, the guy who bet his entire life savings against the BAC buyback/dividend outcome.

 

The way that ERICOPOLY thinks and explains cost seems fascinating to me and worth thinking about.  I have not bought any options and probably will not, at the same time this area is worth understanding, it can be applied to other investments as well.  Cost of leverage and how to compare the different possibilities. It's beautiful. Every choice has a cost. It might seem simple to the pros but not to those who are starting out.

 

On the other hand, you have all these people who invest in the warrants, thinking that because they have 6 or 8 more years they are magically not really options and do not have a certain leverage cost. So maybe you should invite them to your pool first.

 

Having said that, I would love to know (seriously) the Kraven Strategy as you have mentioned you invest in about 20 companies and get great results. So can we start an Ask Kraven/grumpy old man thread (sorry)?

 

 

[oddballstocks]

Time to start a dead pool for some of the posters on this thread.

 

Look who's talking, the guy who bet his entire life savings against the BAC buyback/dividend outcome.

 

The way that ERICOPOLY thinks and explains cost seems fascinating to me and worth thinking about.  I have not bought any options and probably will not, at the same time this area is worth understanding, it can be applied to other investments as well.  Cost of leverage and how to compare the different possibilities. It's beautiful. Every choice has a cost. It might seem simple to the pros but not to those who are starting out.

 

On the other hand, you have all these people who invest in the warrants, thinking that because they have 6 or 8 more years they are magically not really options and do not have a certain leverage cost. So maybe you should invite them to your pool first.

 

Having said that, I would love to know (seriously) the Kraven Strategy as you have mentioned you invest in about 20 companies and get great results. So can we start an Ask Kraven/grumpy old man thread (sorry)?

 

I thought the Kraven strategy (as posted in the annual results thread) was to invest in 100+ companies using Graham/Schloss methods and get 20%+ returns.  To do that Kraven's strategy needs to be just as disciplined as Eric's except there's no sexy factor in buying net-nets, low book value stocks and companies with no brand value.  A muffler companies selling for net cash generates returns but no one is willing to admit they own it..

 

Somehow as the bull market has taken hold this board has come to worship guys who bet the farm on a handful of stocks with can't lose prospects.  I've honestly believed if something was a no lose then bet everything one owns, Eric has done that successfully.  Of any person on this board who touts concentration he is the only one really walking the walk.  If it's a sure thing bet and bet big, and go levered as well, why wimp out?

 

Maybe I'm the sap at the table, I'm still looking for "safe" companies and I'm worried about losses.  I've even sold down positions for cash.  Maybe the market will fall and my strategy will pay off, or maybe I'll look back and say I was an idiot for not following everyone along into the hot investments here….time will tell.

[oddballstocks]

One other thought, back in 2006 after reading the Magic Formula book I worked on modeling it out using LEAPS instead of common stocks.  With what I had modeled out the returns were over 100% a year, the strategy looked like a winner.  I didn't buy in because the potential for an absolute loss loomed large for me.  If I would have gone with the strategy I would have had a year where I made maybe 100-150%, but then in 2007 I would have lost everything.

 

 

[meiroy]

 

 

Another question:

 

Some TARP warrants can only be converted to the common via an exchange of a number of warrants for a common.  The common cannot be bought for additional cash.  Is there any chance that in such an exchange there is no capital gain tax?

 

[meiroy]

Time to start a dead pool for some of the posters on this thread.

 

Look who's talking, the guy who bet his entire life savings against the BAC buyback/dividend outcome.

 

The way that ERICOPOLY thinks and explains cost seems fascinating to me and worth thinking about.  I have not bought any options and probably will not, at the same time this area is worth understanding, it can be applied to other investments as well.  Cost of leverage and how to compare the different possibilities. It's beautiful. Every choice has a cost. It might seem simple to the pros but not to those who are starting out.

 

On the other hand, you have all these people who invest in the warrants, thinking that because they have 6 or 8 more years they are magically not really options and do not have a certain leverage cost. So maybe you should invite them to your pool first.

 

Having said that, I would love to know (seriously) the Kraven Strategy as you have mentioned you invest in about 20 companies and get great results. So can we start an Ask Kraven/grumpy old man thread (sorry)?

 

I thought the Kraven strategy (as posted in the annual results thread) was to invest in 100+ companies using Graham/Schloss methods and get 20%+ returns.  To do that Kraven's strategy needs to be just as disciplined as Eric's except there's no sexy factor in buying net-nets, low book value stocks and companies with no brand value.  A muffler companies selling for net cash generates returns but no one is willing to admit they own it..

 

Somehow as the bull market has taken hold this board has come to worship guys who bet the farm on a handful of stocks with can't lose prospects.  I've honestly believed if something was a no lose then bet everything one owns, Eric has done that successfully.  Of any person on this board who touts concentration he is the only one really walking the walk.  If it's a sure thing bet and bet big, and go levered as well, why wimp out?

 

Maybe I'm the sap at the table, I'm still looking for "safe" companies and I'm worried about losses.  I've even sold down positions for cash.  Maybe the market will fall and my strategy will pay off, or maybe I'll look back and say I was an idiot for not following everyone along into the hot investments here….time will tell.

 

What are you talking about?  Eric himself wrote more than once that it is not a sure thing and that it is a gamble.  If I am not mistaken even when he was "all in" he was still hedged with some puts so in fact it was not all in at all, but maybe I'm wrong.  Using options does not mean you have to go 100% all in, but it can be used to increase leverage for small investors.

 

Below you mention a book by Joel Greenblatt, well this risk:reward guy, wrote about LEAPS in his You Can Be.. and also discusses the weight of the options as part of the whole position.

 

And lets not mention Buffett in his younger days...

 

 

You are right about Kraven:

 

"Dozens of positions.  No position started at larger than ~1% of portfolio.  I invest like my investing idols, Graham and Schloss.  I buy when things are very cheap and sell when they reach IV.  Cash never less than ~30%.  No leverage."