BAC leverage

[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.

 

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."

 

I'm not against options at all, I've used them myself.  I'm not sure if that's what you're getting at, I'm saying if you have a portfolio that's 100% options you run the risk of a complete loss.  An option has an expiration date, once it's past there's no value, a common stock is an ownership interest in something.  If that something has value or not is a separate debate.

 

In past threads I strongly had the impression that Eric felt that at the prices he was buying BAC it was a no-fail proposition.  If you go back through the BAC thread I think a lot of people on the board felt that way.  I have no idea if they still do, but at much lower prices they did.  I believe most established their positions there as well.

 

I was under the impression that Eric bet most of the farm, maybe 80% of his portfolio and kept the rest in cash.  I remember reading one post where he said if he lost it all on BAC his family would still do fine on what he saved.  Not sure if he was hedged or not.

 

A lot of people use leverage their whole life and never have a problem with it.  Let's face it, most entrepreneurs are both levered and 100% concentrated in their single best idea.  Actually most Americans are as well through their mortgages on their homes.

[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?

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.

 

 

Why don't you just plug in the value of a 6 year out-of-the-money put using Black Scholes and compare it to an at the money put?

 

The cost of leverage in the at-the-money put is sky high compared to the out-of-the-money put.

 

So despite the fact that almost everyone here is expecting a big repricing in the common when the underlying earnings shine through this fog of expenses, in about two years time, I can't seem to hammer it into your head that there will still be a 4 year put here at that time.  And the cost of leverage for me to buy it at that time will be far less.

 

Go back to your academics -- they'll tell you that a stock isn't undervalued in the first place because the market is efficient.  Why are you even here if you believe that stuff?  They brought you Black Scholes too by the way.

 

 

[ERICOPOLY]

So how can you claim the X is cheaper than Y if you don't know the cost of X?

 

I do know the worst case cost of X over two years but I don't know the worst case cost of Y (and I'm going to be defensively minded and not take that risk!).  I've calculated "X" already in this thread.

 

Let X be the LEAPS -- over a two year period the leverage will cost me 10% annualized

Let Y be the Warrantss -- over a 6 year period the leverage will cost me 13% annualized

 

I know I can't do worse than 10% annualized if I go with the LEAPS.

 

I could take a gamble and hope that somehow the Warrants will decay at less than 13% annualized rate, but that's getting pretty damned hopeful.  Because if it decays at LESS than 13% rate, it only means the next 4 years will be a higher than 13% rate.  So operating on the greater fool theory, then yes go right ahead and hope you can sell those warrants for a higher cost of leverage in two years time.  Best of luck, because warrant holders are expecting the stock to rise (why else are they in this game?). 

 

Once the stock rises, it's going to crush the value of the leverage embedded in the put.

 

It's a terrible strategy for somebody who is expecting the stock to swing high to the upside (they have a strong opinion of present common stock undervaluation).

 

Black Scholes only understands that the market is efficient.

 

[ericd1]

I've been following this leverage discussion and I believe I understand Eric's strategy. This may be a little simplistic, but I think what he's saying is that the warrants are "ahead" of the common in appreciation and at today's prices the common represents a better value than the warrants.  And if you want to "juice" (leverage) the returns then add some in/near the money leaps because the cost of their leverage is lower than the warrants. He's also suggesting his strategy of adding options is less risky than owning the warrants. 

 

His logic is sound and he's crystallized this thoughts. Nice job!

 

My approach probably won't garner the same gains, but I was comfortable investing across the common, warrants, short ITM options (april/may) and long ITM leaps (jan 14 n 15) - more of a basket approach. So far so good.

[ERICOPOLY]

but I think what he's saying is that the warrants are "ahead" of the common in appreciation and at today's prices the common represents a better value than the warrants.

 

I'm not saying that exactly. 

 

I'm just shopping for cheaper leverage if I can find it.

 

Downside first should be the mantra.  Even when you use leverage, you should first think about the downside.

 

And the downside I'm thinking about with the cost of leverage in those warrants is that Black Scholes will kill off the value of their embedded puts when the stock reprices to "normalized earnings" once the expenses at BAC runoff over the next two years.

 

Ironically people keep thinking I'm missing something with regards to Black Scholes.

 

I fully understand the market relies on Black Scholes and that's why I'm staying the hell away from the warrants for now.  Once the market reprices the BAC common (in two years) I will look again at the warrants after Black Scholes reprices their leverage.

 

I don't see how it can be any more obvious -- Black Scholes relies on an efficient market... that reliance gets exposed by undervalued securities that reprice long before warrants expire.  So it's a bizarre case that value investors who don't believe in efficient markets would consider wading into the warrants for a stock they strongly believe to be undervalued. It's like a suicide mission of opportunity cost in the amount they are overpaying for their leverage in the years after the repricing of the common.

 

 

 

 

 

[stahleyp]

eric, if you don't me asking, what percent are you in the options vs common vs warrants? still holding onto the aig warrants or are the options looking better there, too? Thanks in advance!

[ericd1]

but I think what he's saying is that the warrants are "ahead" of the common in appreciation and at today's prices the common represents a better value than the warrants.

 

I'm not saying that exactly. 

 

I'm just shopping for cheaper leverage if I can find it.

 

Downside first should be the mantra.  Even when you use leverage, you should first think about the downside.

 

And the downside I'm thinking about with the cost of leverage in those warrants is that Black Scholes will kill off the value of their embedded puts when the stock reprices to "normalized earnings" once the expenses at BAC runoff over the next two years.

 

Ironically people keep thinking I'm missing something with regards to Black Scholes.

 

I fully understand the market relies on Black Scholes and that's why I'm staying the hell away from the warrants for now.  Once the market reprices the BAC common (in two years) I will look again at the warrants after Black Scholes reprices their leverage.

 

I don't see how it can be any more obvious -- Black Scholes relies on an efficient market... that reliance gets exposed by undervalued securities that reprice long before warrants expire.  So it's a bizarre case that value investors who don't believe in efficient markets would consider wading into the warrants for a stock they strongly believe to be undervalued. It's like a suicide mission of opportunity cost in the amount they are overpaying for their leverage in the years after the repricing of the common.

 

Have you tried to estimate the incremental return advantage for your strategy or does it even matter given your cost of leverage is lower than alternatives?

 

 

[ERICOPOLY]

eric, if you don't me asking, what percent are you in the options vs common vs warrants? still holding onto the aig warrants or are the options looking better there, too? Thanks in advance!

 

I haven't done anything with the AIG warrants yet -- will get to that soon (haven't done any comparison shopping yet). 

 

I have about 140% long notional value net worth upside exposure to BAC (140% of net worth upside in BAC).  100% of the leverage in the BAC position is hedged near-the-money with either the puts embedded in $12 strike LEAPS or the puts embedded in $10 strike LEAPS.

 

Then I have a bunch of ultra cheap November 13 puts at strike like $7 and $5.  Just in case!  They cost almost nothing for peace of mind in a going-to-zero black swan.  Plus the puts will offset my short-term gains so they don't cost much considering the IRS gets a chunk of it anyhow.

 

Then I have about 12% exposure to AIG warrants (down from 25% recently so that I can have cash for a house). 

 

I have roughly 25% of net worth hedged by the ultra-cheap BAC puts at $5 and $7 strike.

 

So really I have about 37% of net worth left if BAC alone is at zero tomorrow.  Less if AIG is down too. 

 

I might just write some $22 strike LEAPS calls and use the proceeds to purchase $7 strike LEAPS puts.  Then I can bring my BAC downside way, way down, with almost zero added cost!  Oh yes, I forgot, options are risky.  BAC is going to soar past $22 and then I'll find out the real cost of that strategy!  Oh wait, that's fine too!

 

I'm looking at writing the $22 strike because I want to ride the steep part of the revaluation curve with leverage, prepared to hold until maturity in two years.  I figure it will take about that much time anyhow.  Will probably only write covered call on the leverage portion of my holding -- that way if the stock rallies quickly to $20 I can dump a lot of the stock without the headache of soaring covered calls being bought back at a loss.

 

 

 

[ERICOPOLY]

Have you tried to estimate the incremental return advantage for your strategy or does it even matter given your cost of leverage is lower than alternatives?

 

I haven't, I just know it's better to have a 5% hurdle rate than a 13% hurdle rate.  When BAC is at $20 the cost of a $12 put may very well be a 7% hurdle rate (including the cost of the margin loan).  Or it might be as low as a 3.5% hurdle rate (1% margin loan).

 

Just look at the $7 LEAPS put today 33 cents!  They're priced at a cost of 2.5% annualized!

 

I hope everyone with the warrants is seeing that the leverage will NOT COST AS MUCH AS 13% when the puts with the same strike cost 2.5% annualized.

 

The cost of leverage will be the puts plus the margin interest rate.  Whatever that rate is.  It could be as high as 10.5% margin interest rate (matching that of the warrants).

 

People said the warrants hedge them against high interest rates... well... so does my strategy.  10.5% margin rate!  Likely the margin rate plus cost of put will be somewhere in between.  Maybe 5% or 6%.  Maybe 8%.  But 13%???

 

 

 

 

 

[Redskin212]

Eric,

 

I have spent the past hour or two trying to fully understand your thinking -- I think I have finally got it.  For me I like to make it as simple as possible and to do so I looked at the performance of the following securities today.

 

BAC - 3.8% increase to $12.57

 

Jan 15 $10 Calls - 10.7% increase to $3.60

Jan 15 $12 Calls - 11.6% increase to $2.40

Jan 15 $15 Calls - 15.4% increase to $1.27

 

BAC A Warrants - 1.9% increase to $5.69

BAC B Warrants - $5.2% increase to $0.81

 

 

Something with the A warrants is not right! I believe it is a combination of two themes that you have been explaining:  1) the leverage or cost of the warrants is much higher that the options and 2) Dividends - as you said with the A warrants you are effectively prepaying for the dividend and we now know we have prepaid for something that we will not receive this year.

 

I hope I understand.  My dilemma now is how to restructure my wad of A warrants to options/common.

 

Thanks for all your patience.

 

[racemize]

I just modeled what the prices of the A warrants would be under Eric's decrease to 10% leverage scenario, here are the results (if I did the math right):

 

At Jan 2015, the common is $20.00 (for fun)

At this point, Eric indicated that the cost of leverage could be ~10% rather than 13% (or at least a lower amount, similar to other banks upon reaching normalized earnings), so the new break even will be four more years of 10% growth for the common, which yields you $29.28.  At that point, the warrant is worth $29.28 - strike price, which I left at $13.30, conservatively, which yields $15.98.  Backing out the 10% growth from there gives us the warrant price at 10% cost of leverage with a stock price of $20, which happens to be $10.92.  As a result:

 

Growth of warrant from current price to $10.92 = 91.2%

Growth of common from current price to $20 = 59.1%

 

Edited for clarity

 

[ERICOPOLY]

Something with the A warrants is not right! I believe it is a combination of two themes that you have been explaining:  1) the leverage or cost of the warrants is much higher that the options and 2) Dividends - as you said with the A warrants you are effectively prepaying for the dividend and we now know we have prepaid for something that we will not receive this year.

 

I hope I understand.  My dilemma now is how to restructure my wad of A warrants to options/common.

 

Thanks for all your patience.

 

 

Don't forget the most important part.  Black Scholes determined the price of that leverage in the warrant.

 

Take a look for yourself at the cost of leverage expressed as a percentage of strike:

 

at-the-money puts/calls have the highest cost of leverage

deeply out-of-the-money or deeply in-the-money have the lowest cost of leverage

 

 

The price of the warrants will be fighting a headwind as the stock rises significantly above that warrant strike price.  Think of the warrant as containing 6 years worth of puts dropping like a stone in value as the warrant goes deep-in-the-money.

 

 

Everyone who has ever tried to short a stock with puts knows that when the stock rises dramatically, the value of the puts drops dramatically.

 

So the value of those puts (six years of them) are embedded in the value of the warrants.

 

High stock price?  Poof!!!!

 

 

 

[racemize]

I have about 140% long notional value net worth upside exposure to BAC (140% of net worth upside in BAC).  100% of the leverage in the BAC position is hedged near-the-money with either the puts embedded in $12 strike LEAPS or the puts embedded in $10 strike LEAPS.

 

I realize I'm likely being completely dense here, but how can you have the embedded put if you are more than 100% long?  Doesn't it require you to have kept the cash you would have had to have the put?  I mean yes, you only lost the amount you put in, but you still lost of all that amount, so this only works out if you put less in than you would have had it been a different vehicle.

 

e.g., if you would have bought 1 common, you only buy 1 warrant or 1 LEAP rather than the same amount of money.

 

[zippy1]

Eric,

 

      I really appreciate that you took time to explain this.  I think it makes senses.  This is really any eye-opener for me. 

 

      I finally figured out what you meant on Thursday morning. For the part of my portfolio related to BAC, I restructured it into Jan 15 calls and common instead of class warrants on Thursday morning just in time before the stress test announcement. 

 

      Speaking of lucky timing, the Jan 15 $12 call did get a much bigger kick than the common and the common did get a bigger kick than the class A warrants.

 

        Thanks again for sharing your thoughts.

 

       

[ERICOPOLY]

At Jan 2015, the common is $20.00 (for fun)

At this point, Eric posits that the cost of leverage will be ~10% rather than 13%

 

No I didn't! 

 

I feared that if that were the case, I'd have wasted a money by purchasing leverage at 13% cost that could later be resold at only 10% cost.

 

I pulled the 10% out of thin air -- don't rely on it!  I never meant for anyone to mistake it for what I expect it to be at. 

 

Run it again, but this time use Black Scholes to tell you what it will be.  Remember, at that point (if the stock is at $20) people will be really bullish on BAC.  By definition practically, the uncertainty will be lifted.  There will be little volatility priced into the warrants.

 

 

 

 

[ERICOPOLY]

I have about 140% long notional value net worth upside exposure to BAC (140% of net worth upside in BAC).  100% of the leverage in the BAC position is hedged near-the-money with either the puts embedded in $12 strike LEAPS or the puts embedded in $10 strike LEAPS.

 

I realize I'm likely being completely dense here, but how can you have the embedded put if you are more than 100% long?  Doesn't it require you to have kept the cash you would have had to have the put?  I mean yes, you only lost the amount you put in, but you still lost of all that amount, so this only works out if you put less in than you would have had it been a different vehicle.

 

e.g., if you would have bought 1 common, you only buy 1 warrant or 1 LEAP rather than the same amount of money.

 

If I have $12 dollars, and I purchase a $12 strike call (keeping the rest in cash) I am 100% notional value long.

[racemize]

At Jan 2015, the common is $20.00 (for fun)

At this point, Eric posits that the cost of leverage will be ~10% rather than 13%

 

No I didn't! 

 

I feared that if that were the case, I'd have wasted a money by purchasing leverage at 13% cost that could later be resold at only 10% cost.

 

I pulled the 10% out of thin air -- don't rely on it!  I never meant for anyone to mistake it for what I expect it to be at. 

 

Run it again, but this time use Black Scholes to tell you what it will be.  Remember, at that point (if the stock is at $20) people will be really bullish on BAC.  By definition practically, the uncertainty will be lifted.  There will be little volatility priced into the warrants.

 

I wasn't relying on it, just showing what it would look like, return wise.  As you indicated, the more stable banks are currently around 8-10%, rather than the 13% of BAC, I believe.  Didn't mean to put words in your mouth, but was just using your example.

[racemize]

I have about 140% long notional value net worth upside exposure to BAC (140% of net worth upside in BAC).  100% of the leverage in the BAC position is hedged near-the-money with either the puts embedded in $12 strike LEAPS or the puts embedded in $10 strike LEAPS.

 

I realize I'm likely being completely dense here, but how can you have the embedded put if you are more than 100% long?  Doesn't it require you to have kept the cash you would have had to have the put?  I mean yes, you only lost the amount you put in, but you still lost of all that amount, so this only works out if you put less in than you would have had it been a different vehicle.

 

e.g., if you would have bought 1 common, you only buy 1 warrant or 1 LEAP rather than the same amount of money.

 

If I have $12 dollars, and I purchase a $12 strike call (keeping the rest in cash) I am 100% notional value long.

 

aha, I was being dense.  So how much cash does that leave you in your account then (% wise)?

[ERICOPOLY]

I have about 140% long notional value net worth upside exposure to BAC (140% of net worth upside in BAC).  100% of the leverage in the BAC position is hedged near-the-money with either the puts embedded in $12 strike LEAPS or the puts embedded in $10 strike LEAPS.

 

I realize I'm likely being completely dense here, but how can you have the embedded put if you are more than 100% long?  Doesn't it require you to have kept the cash you would have had to have the put?  I mean yes, you only lost the amount you put in, but you still lost of all that amount, so this only works out if you put less in than you would have had it been a different vehicle.

 

e.g., if you would have bought 1 common, you only buy 1 warrant or 1 LEAP rather than the same amount of money.

 

If I have $12 dollars, and I purchase a $12 strike call (keeping the rest in cash) I am 100% notional value long.

 

aha, I was being dense.  So how much cash does that leave you in your account then (% wise)?

 

Zero cash.  I have a margin account.  It routinely (every month) transfers my "paycheck" to my Wells Fargo checking account where I pay my bills.

 

I have enormous margin borrowing power -- I hedge all of the margin loan directly with the underlying security.  It is a very tiny margin loan -- I have more than $2m "available cash" in the account according to IB.  To keep that from suddenly vanishing, I keep the hedges in place.

 

[racemize]

aha, I was being dense.  So how much cash does that leave you in your account then (% wise)?

 

Zero cash.  I have a margin account.  It routinely (every month) transfers my "paycheck" to my Wells Fargo checking account where I pay my bills.

 

I have enormous margin borrowing power -- I hedge all of the margin loan directly with the underlying security.  It is a very tiny margin loan -- I have more than $2m "available cash" in the account according to IB.  To keep that from suddenly vanishing, I keep the hedges in place.

 

Ok, back to being dense again--how can you have an embedded put without any cash?  or said another way, how can the strikes give you "hedging"?

 

Perhaps you mean that they are hedged only when discussing them in terms of notional value?

[ERICOPOLY]

aha, I was being dense.  So how much cash does that leave you in your account then (% wise)?

 

Zero cash.  I have a margin account.  It routinely (every month) transfers my "paycheck" to my Wells Fargo checking account where I pay my bills.

 

I have enormous margin borrowing power -- I hedge all of the margin loan directly with the underlying security.  It is a very tiny margin loan -- I have more than $2m "available cash" in the account according to IB.  To keep that from suddenly vanishing, I keep the hedges in place.

 

Ok, back to being dense again--how can you have an embedded put without any cash?  or said another way, how can the strikes give you "hedging"?

 

Perhaps you mean that they are hedged only when discussing them in terms of notional value?

 

It works like this:

 

2 parts $12 strike LEAPS calls  (12 strike embedded puts)

1.5 parts $10 strike LEAPS calls (10 strike embedded puts)

4 parts BAC common stock

 

Then lots of puts on $7 strike and $5 strike to protect my margin borrowing capacity.

 

 

 

[ERICOPOLY]

I just modeled what the prices of the A warrants would be under Eric's decrease to 10% leverage scenario, here are the results (if I did the math right):

 

At Jan 2015, the common is $20.00 (for fun)

At this point, Eric indicated that the cost of leverage could be ~10% rather than 13% (or at least a lower amount, similar to other banks upon reaching normalized earnings), so the new break even will be four more years of 10% growth for the common, which yields you $29.28.  At that point, the warrant is worth $29.28 - strike price, which I left at $13.30, conservatively, which yields $15.98.  Backing out the 10% growth from there gives us the warrant price at 10% cost of leverage with a stock price of $20, which happens to be $10.92.  As a result:

 

Growth of warrant from current price to $10.92 = 91.2%

Growth of common from current price to $20 = 59.1%

 

Edited for clarity

 

Note that you are taking on 2.2x notional leverage with putting 100% in the warrants vs 100% in the common.

 

2.2x leverage (if non-recourse leverage costs were completely free) would have given you:

 

130.6% (just multiply the common's gain by 2.2x)

 

So the leverage of the warrants in your scenario costs:

 

130.6% - 91.2% = 39.411%

 

The reason why 39% cost is a hell of a lot more than 13% per annum is because of the repricing of the leverage.

 

So there you go.  Paid roughly 50% more for the leverage over the two year time period because of the decay in value of the remaining 4 years of leverage. 

[ERICOPOLY]

I just modeled what the prices of the A warrants would be under Eric's decrease to 10% leverage scenario, here are the results (if I did the math right):

 

At Jan 2015, the common is $20.00 (for fun)

At this point, Eric indicated that the cost of leverage could be ~10% rather than 13% (or at least a lower amount, similar to other banks upon reaching normalized earnings), so the new break even will be four more years of 10% growth for the common, which yields you $29.28.  At that point, the warrant is worth $29.28 - strike price, which I left at $13.30, conservatively, which yields $15.98.  Backing out the 10% growth from there gives us the warrant price at 10% cost of leverage with a stock price of $20, which happens to be $10.92.  As a result:

 

Growth of warrant from current price to $10.92 = 91.2%

Growth of common from current price to $20 = 59.1%

 

Edited for clarity

 

So using current stock price of $12.57 and current $12 LEAPS call price of 2.45, I'll show you how to get that same warrant return with less leverage:

 

 

1 shares $12 LEAP call = $2.45 cash outlay

 

$10.12 in remaining cash buys .805 shares common

 

Total notional leverage is 1.8x

 

At $20 per share:

 

1 x $8 = $8

.805 x $20 = $16.1

 

$8+$16.1= $24.1

 

So we have $24.1 total which is 91.7% upside.  (slightly better than the 100% warrant approach)

 

Yet we used "only" 1.8x leverage vs 2.2x in the warrant.

 

[yitech]

Eric,

 

Thanks for the insights. I rarely comments on the board.. mainly trolling, but I do appreciate you sharing your strategy and framework of thinking in terms of options. Anything with leverage whether recourse or non-recourse isn't for the fainted of heart. Anyone who would like to leverage his or her portfolio multiple times can do so, but should also learn how to hedge or get out when disaster strikes. Stay in one's circle of competence I guess. That said, I enjoy reading your materials and help me clarify my own thinking in terms of leverage.

 

I believe what you described in terms of 13% vs 10% cost of leverage is a phenomenon called volatility skewness where further in-the-money calls tend to have lower implied vol (or cost of leverage in Eric's term). Opposite things happen for puts when disaster strikes, the skew together with a sudden spike of vol can make put options valuable. The A warrant share does exhibit unusually high implied vol whether or not you include the optimistic forecast of $10 strike & 1.2 shares at expiration. Like Eric described, one could customize/manufacture his or her own leverage via common+leaps to create shorter term (<2 years) form of leverage. If you believe BAC's earning power/stock price will normalize with 3 years (<2 yrs might be a bit optimistic), the extra 3 years of leverage offered by the A shares is essentially wasted when it becomes deep in-the-money and implied vol normalizes to reflect the skewness.

 

Again, I appreciate Eric sharing his insights!

[Kraven]

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."

 

First of all, I didn't bet my life savings against the BAC buyback/dividend outcome, it was more like half of it.  So even if I lose I probably have $1 or so left.  So don't worry about me.  That and government assistance from the all the good folks in America will keep me and my family just fine.  I don't actually invest much, maybe a few dollars here and there if at the end of the month my public assistance debit card has a little room left on it.  I just find that living in the shelter gets lonely during the day sometimes so I like to hang out on this board. 

 

In terms of the dead pool, there are still viable candidates.

 

An Ask Kraven thread?  Damn, son, why if that isn't the finest idea I've heard since they added meat in the gravy here at the shelter.  Please feel free to start it and ask the first question.  I am happy to share my curmudgeonly wisdom.  Oops, sorry, got to go.  The attendants here don't like it if you take up the computer time too long.