BAC leverage

[ERICOPOLY]

Ericopoly , in the worst case is that there is another 2009-style crisis in 2015, all your $12 calls expire worthless and immediately afterwards the stock rises back to 50. In which case the guy with the warrants will be far, far, far better off. The fact that you have this extra 'optionality' in the warrants means that they should always trade at a premium. Your model ignores this possibility (and I get the feeling that you do not worry about it either) and thus you end up buying short term at the money calls because these have the lowest implied volatility. In English: these are the cheapest options because they are the easiest to price and the least risky to sell (and thus the riskiest to buy).

 

Imho, this has nothing to do with 'playing the fool's game'. The options market has evolved to transfer risks between market participants. I think that your pricing model ignores risk completely and that you confuse it with the cost of leverage. So when you say you swapped into an option position with a lower cost of leverage, you actually just bought a cheaper option portfolio that sets you up to get screwed when something strange happens like in 2009.

 

So yeah, pretty much what Sunrider said (but he was much more to the point and much faster).

 

 

A 2009 style crash helps the businessman, it doesn't hurt him.  It creates opportunity.

 

You guys do recognize we're talking about non-recourse loans, right?  I only lose my "cost of leverage".  A businessman loses 10% a year if he borrows money at a 10% rate.

 

Fairfax "loses" the rate of interest costs each year at their holding company.  They lose the same amount whether or not a crash is happening.

 

Are you guys just trying to mess with my head?

 

Look, the incremental cost of rolling the 2015 $12 strike calls into the 2016 $12 strike calls will be lower if there is a major crash underway -- somebody above told me the correct term for this is "skewness".  As the calls go further out of the money they drop more rapidly.

 

 

 

 

[ERICOPOLY]

So if buying non-recourse leverage is like buying groceries, I should be happy then if the price of bananas goes on sale.

[bargainman]

I'm still working my way through this thread, so sorry if this has already been posted.  Jeesh I go away for 1-2 days and have 6 pages of heavy reading on this topic alone!!! :-)

 

2 things I wanted to mention before I forget as I read through the thread.

1. Eric talked about buying stock and selling the warrant short.  This is basically the equivalent of a very long term covered call position.

2. Eric talked about setting up a margin loan with equity + puts.  If you want to lever up to the same as a call, you should first be very very careful, but second you could look at applying for portfolio margin in your account, and if you do be very very very very careful!!!  But portfolio margin essentially should let you lever up the same way you could with calls but with the equity+puts.  Your margin loan would still cost money but the limits there are calculated based on portfolio risk analysis not reg-t margin, so in a stock+put scenario they'll let you lever up to the equivalent of a long call if I'm remembering correctly.  But like I said be very very careful, portfolio margin has led to many bad things.  Leverage is dangerous..

 

On to reading the rest of the thread... :-)

[racemize]

 

Start with

(a) 12.57 + 2.57 so I'm long 2 shares

(b) 2 x 5.50 so I'm also long 2 shares with 4.02 in cash left over; assume cash earns nothing for the next 2 years

 

 

You are comparing "ALL IN" strategy to one where a lot of cash is not even invested.

 

I believe a more fair comparison would be:

 

(a)  2.57x2 with $10 in cash left over so I'm long 2 shares

(b)  5.50x2 with $4.02 in cash left over so I'm long 2 shares

 

There, now that both strategies each have a put per share, we can compare them.

 

After all, if you've already made a decision to hedge each share of upside (in order to leave cash on side), it's only a matter now of deciding how we can contain the cost of leverage.

 

 

(also, it's 5.69 cost of the warrant today at yesterday's close.  you've updated the cost of the $12 call since this discussion began when it was $2.10 and was at-the-money.  It's now slightly in the money, and the warrant costs a bit more now.  It's 5.69 now.)

 

Ok, fair enough - so we'd change (a) to 2x2.57 and 10 in cash

 

Good scenario (20):

(a) 10+(8-2.57)x2 = 20.86

(b) as before, so less than above and assumption about market value of warrants required

 

Bad scenario (11.99)

(a) 10 + 0 = 10

(b) as before, also an assumption of the market value required, but likely that uncertainty will not have subsided and thus 'cost of leverage' remains elevated.

 

Either way - if you're right on the upside you win more with the LEAPS (both because you pay for less optionality so your cost base is lower = more leverage and because you risk re-pricing to the downside for the warrants as uncertainty subsides). If you're wrong on the upside (and depending on how wrong), you will likely be happier with the warrants as are much less likely to have re-priced to the downside.

 

There's no magic bullet. There's no solution that gives an optimal trade-off in all scenarios. You have to craft your strategy according to your beliefs. You believe BAC will be substantially higher than today - so you chose the LEAPS (and that makes absolute sense). Someone else believes that there is also some chance that BAC will remain at this level or decline a bit before increasing substantially as earnings normalise in, perhaps, 2015/16, consequently they may be happier having some exposure to 2015 through LEAPS (or common or both) and some exposure to the period after that.

 

Cheerio.

 

C.

 

Eric, could you address the reason the leaps are still better in the above, bad scenario?  Is it that you would just roll them, losing money along the way, but eventually, the pay out would be more than the warrants on the normalization (due to the lower cost of leverage)?

 

It just seems as though there has to be some cases where the leaps do not pay or do as well as the warrants, and I have not seen you address those situations.

[bargainman]

Investmentacct,

 

"Annual volatility 50%"

 

Black Scholes works and I think it would save a lot of time to the members here trying to compare cost of various options of various strikes and expirations. The formula gives you that via implied volatility. This cost of leverage idea is really the same thing, but quite tedious to calculate at times. We are reinventing the wheel here. Black Scholes is not casino talk!

 

Now, here is the problem with these BAC "A" warrants and it is the implied volatility being at around 53% currently. That is why Ericopoly is finding out that they are very expensive leverage relative to other call options which show 30% implied volatility. It is also worth wondering if your assumption of holding 50% in the future would hold or why I have highlighted your quote.

 

If the market is truly dumb enough to pay this kind of premium for nothing then there is an arbitrage solution here and it is to short them and buy calls and you would not even have to worry about what BAC does to make money. It seems highly unlikely to me considering that there are people and powerful computers hunting constantly just for that. These are not mysterious securities and a couple million $ worth of these change hands daily. Such a difference would not be ignored and would not have lasted for as long as it has. Implied volatility is what they use to compare options pricing and they arbitrage accordingly.

 

There is something bigger at work here and it has to be in the adjustment features that some have mentioned. I imagine that someone (many indeed and algorithms) out there has modeled that using a modified Black Scholes version and that is why there is a premium paid for said warrants. I also mentioned that warrants are different than options since there is more of a supply/demand dynamic at work vs straight options, but the difference here is just too large and has lasted for way too long.

 

Maybe also that it is the expectation of dividend growth and strike adjustment that is out of whack in the model, but that seems awfully odd since it would be the expectations of all market participants which are not that warm after all on BAC at a price of $12. Like for options that re-price when a dividend is increased or paid, the same apply to the warrants. They are derivatives too and priced based on what information is there today.

 

Cardboard

 

Cardboard, where are you finding the Implied volatility for BAC-WTA?  Ie, are you calculating it or are you getting it from a public website?  Thanks.

[ERICOPOLY]

I'm still working my way through this thread, so sorry if this has already been posted.  Jeesh I go away for 1-2 days and have 6 pages of heavy reading on this topic alone!!! :-)

 

2 things I wanted to mention before I forget as I read through the thread.

1. Eric talked about buying stock and selling the warrant short.  This is basically the equivalent of a very long term covered call position.

2. Eric talked about setting up a margin loan with equity + puts.  If you want to lever up to the same as a call, you should first be very very careful, but second you could look at applying for portfolio margin in your account, and if you do be very very very very careful!!!  But portfolio margin essentially should let you lever up the same way you could with calls but with the equity+puts.  Your margin loan would still cost money but the limits there are calculated based on portfolio risk analysis not reg-t margin, so in a stock+put scenario they'll let you lever up to the equivalent of a long call if I'm remembering correctly.  But like I said be very very careful, portfolio margin has led to many bad things.  Leverage is dangerous..

 

On to reading the rest of the thread... :-)

 

In the real world I am using LEAPS calls instead of margin+puts.

 

However, when I take delivery of the common I may (depending on market prices of the common) go the route of using some margin to take delivery on the shares.  Note that if the common stock is at $14 or less I will just roll the calls.

 

Of course, if the stock is at $20 I won't have much if any appetite for leverage.  I only want to leverage the steep part of the appreciation, which is the rise to "normalized earnings".

 

 

Somebody earlier said that they can get up to 2.2x leverage with the warrants but that I can't do so with the margin+puts.  I agree with them, but I also don't want 2.2x leverage!  This isn't a game of where can I get the most leverage.  I just want the leverage that I want, and then I want to find a cheaper way of getting it.  I am going with a mix of common+LEAPS and my leverage is "only" 1.5x.  But most of that leverage is either at-the-money or near-the-money calls, so I sleep like a baby.

[ERICOPOLY]

Eric, could you address the reason the leaps are still better in the above, bad scenario?  Is it that you would just roll them, losing money along the way, but eventually, the pay out would be more than the warrants on the normalization (due to the lower cost of leverage)?

 

Bingo!  I'm a businessman looking for the lowest cost of financing non-recourse leverage.  I'm simply trying to finance the leverage of an appreciating asset.

 

 

It just seems as though there has to be some cases where the leaps do not pay or do as well as the warrants, and I have not seen you address those situations.

 

I haven't read those cases. 

 

I've been too busy battling people who claim I'll lose 100% of my cost of financing.

 

My answer to that is basically, well "No shit, Sherlock!".  Losing 100% of the cost of financing is business 101.  Or I don't even think you need a class for that.

 

Who here thinks they can find 0% non-recourse loans?

[compoundinglife]

Ericopoly , in the worst case is that there is another 2009-style crisis in 2015, all your $12 calls expire worthless and immediately afterwards the stock rises back to 50. In which case the guy with the warrants will be far, far, far better off. The fact that you have this extra 'optionality' in the warrants means that they should always trade at a premium. Your model ignores this possibility (and I get the feeling that you do not worry about it either) and thus you end up buying short term at the money calls because these have the lowest implied volatility. In English: these are the cheapest options because they are the easiest to price and the least risky to sell (and thus the riskiest to buy).

 

Imho, this has nothing to do with 'playing the fool's game'. The options market has evolved to transfer risks between market participants. I think that your pricing model ignores risk completely and that you confuse it with the cost of leverage. So when you say you swapped into an option position with a lower cost of leverage, you actually just bought a cheaper option portfolio that sets you up to get screwed when something strange happens like in 2009.

 

So yeah, pretty much what Sunrider said (but he was much more to the point and much faster).

 

 

A 2009 style crash helps the businessman, it doesn't hurt him.  It creates opportunity.

 

You guys do recognize we're talking about non-recourse loans, right?  I only lose my "cost of leverage".  A businessman loses 10% a year if he borrows money at a 10% rate.

 

Fairfax "loses" the rate of interest costs each year at their holding company.  They lose the same amount whether or not a crash is happening.

 

Are you guys just trying to mess with my head?

 

Look, the incremental cost of rolling the 2015 $12 strike calls into the 2016 $12 strike calls will be lower if there is a major crash underway -- somebody above told me the correct term for this is "skewness".  As the calls go further out of the money they drop more rapidly.

 

Now this may sound paranoid... but I think its worth bringing up. In the case of the some crazy systematic event there are chances that the options market could be closed for some duration of time or something else crazy happens that would prevent you from being able to roll over your position and the by time you are able to you are already toast or its not attractive. Obviously this is very unlikely but when considering big bets I try to think of all the possibilities of how I lose.

 

With the warrants if the markets close for the next 3 years it doesn't really matter, if the markets close for the next 5 years its cutting it really close. Also the counter party with the warrants is BAC. Not really sure what happens with derivatives if the market was closed for any period of time overlapping with the expiration date. Does anyone know, has this ever happened before?

 

Now you could say if something crazy like that happens you will have worse problems than your position. But the extra flexibility of having a longer time horizon doesn't matter until it does and when it does it could make a very big difference. This is really the one thing that prevents me from going big with a options position instead of a combination of stock/warrants/options with options being the smallest %.

 

But in general I feel with the warrants there is a lower chance of a decision being made for me because of some crazy unforeseen event. Hence I own way more warrants than calls.

 

Anyways, just figured I would mention it. Am I crazy and paranoid? Maybe :) But I think there is some intangible value in the longer duration instruments.

 

I guess though it also depends on how you do this. If you go all in notional and keep your cash in something safe so you can put this position on in some other fashion when the panic ensures then probably not as scary. Assuming that in that worst case scenario there is a way to put the position back on. If you go "all in" "all in", then you would be effed.

[Sunrider]

Ericopoly , in the worst case is that there is another 2009-style crisis in 2015, all your $12 calls expire worthless and immediately

 

Are you guys just trying to mess with my head?

 

Look, the incremental cost of rolling the 2015 $12 strike calls into the 2016 $12 strike calls will be lower if there is a major crash underway -- somebody above told me the correct term for this is "skewness".  As the calls go further out of the money they drop more rapidly.

 

Ermm - I'm not sure what exactly you mean with 'lower' here - here is what I would think we'd see:

 

- stock price in the back-end of 2013 drops significantly

- consequently the 2015 leaps go down significantly

- the 2016 leaps, which will be available somewhere around this time, will -of course- be cheaper than what they would otherwise be.

 

However, given the starting cost you had with the 2015 LEAPS and the loss you're taking on selling those, I'm not sure if your overall 'roll' still works out to be 'cheaper'. Maybe I'm just not understanding what you mean. In any case, in this particular scenario you will take some loss on the 2015s and you then hope that the stock recovers over the course of the 2016 LEAPS and that you don't have to roll at a loss again.

 

So once more, it's back to your assumption around where the stock is at each expiration (or roll date) - i.e. what the path is to 2018.

 

Nothing wrong with that. If you're right and you're long the cheap options (as per writsers post) then you'll make out better than in the warrant. How much better will depend on the price behaviour and how that differs from what the market currently assumes it to look like (you call it the cost of leverage - whatever term to choose here, it does matter that assuming this is an average/linear measures is, in my view, dangerous). You could end up being right with the price prediction on every LEAP cycle, in which case you make out like a bandit compared to the warrants. Or you could be wrong on each of them until the very last one where you're right. In that scenario you 'pay' through the negative roll yield and end up with a smaller position than what you would presumably have taken in the warrants. Whether you then make up for that disadvantage by a stellar return on the last cycle will, I think, again depend on the price path to that point (i.e. how much you had to give up) and how high the price goes in that last cycle (simplistically speaking).

 

C.

[Sunrider]

A more general question:

 

I use an IB portfolio margin account (to a previous poster: the IB platform is also where I get IV estimates). This, unfortunately, makes it difficult to disentangle margin requirements sometimes.

 

What's the Reg-T margin rule for long calls?

 

Eric: Are you using a Reg-T margin or Portfolio Margin account?

 

Thanks - C.

[Studesy]

 

 

Eric, could you address the reason the leaps are still better in the above, bad scenario?  Is it that you would just roll them, losing money along the way, but eventually, the pay out would be more than the warrants on the normalization (due to the lower cost of leverage)?

 

It just seems as though there has to be some cases where the leaps do not pay or do as well as the warrants, and I have not seen you address those situations.

 

The way I understand Eric's reasoning is that regardless of what happens the downside is going to be less in the LEAPS than in the warrants.  He is essentially engineering a strategy with the LEAPS (via rolling them over as new series come out) so that he has an equivelent vehicle to compare to the warrants.  The cost of the leverage embedded in those two equivalent vehicles is lower going the LEAP route, there there is less risk (downside).  When the next series of LEAPS is issued (or at any point in time) if the cost of leverage in LEAPS goes up relative to that in the warrants...it may make sense to switch over to warrants...you are always invested in the most cost effective (risk adverse) of two essentially equivalent choices.  In 2017 when the 2019 LEAPS come out...it will be more obvious when comparing them because they will visibly become two essencially identical instruments.  As long as you are on the right side of the fence (the lower cost of leverage side) then you will gain as the prices merge.     

implied cost of the embedded leverage is lower for the LEAPS than for the warrants.

This is the way I am seeing this. Any thoughts??

BTW  Awesome discussion to everyone involved!!

[Studesy]

MY last post was supposed to respond to a question from Racemize.  For some reason it didn't show up as a quote properly.

Sorry bout that.

[Sunrider]

 

 

 

The way I understand Eric's reasoning is that regardless of what happens the downside is going to be less in the LEAPS than in the warrants.  He is essentially engineering a strategy with the LEAPS (via rolling them over as new series come out) so that he has an equivelent vehicle to compare to the warrants.  The cost of the leverage embedded in those two equivalent vehicles is lower going the LEAP route, there there is less risk (downside). 

 

No, I don't think so - by that I mean not that I don't think that's what Eric is thinking but rather that I don't think that you can engineer it this way. What you can do is figure out that the LEAPS are cheaper than the warrants assuming a specific price at expiration.

 

You can also figure out the cheapest way to go assuming a price path (or at least price points) at each roll. Note, however, that your are then setting yourself on a specific scenario that may or may not actually occur. If it doesn't occur then it may be that you've made a sub-optimal choice in the instrument you went with.

 

The trouble here is that we always have to speculate about the future pricing of BAC, which is hard (I'm sure there's a Yogi Berra quote about this). So yes you can assume that you can roll but you don't know at what price you'll be able to. For example - assume by the time the 2016 come out later this year BAC is trading at 9 or 10 (making up numbers now, not using any sort of model). Perhaps the 2015s will then have gone down to 50c. Where would the 2016s trade? Well, since they are the same as the 2015s except for one more year of time, they must be more expensive than the 2015s, ... say perhaps 60c?

 

So, whilst you paid something (maybe 2.5) for the 2015s today, you'll take a 2 dollar loss on selling them then to roll. You will only have to pay 60c for the 2016s but if you started with a fixed amount and do not wish to add more to the portfolio then, you may have an issue. Say you started with 100 and bought 50 calls. You sell these for 0.5c so you end up with 50x50c = 25. You now spend 25 on the 2016s, which buys you 41 calls (rounded down). Your net long exposure has reduced.

 

The same may/may not happen at the next roll. Hence my observation that you'd have to assume what the price is at each roll to figure out whether you want to go that route to the end. If one is very sure that BAC will trade at, say, 16 later this year when one wants to roll, then yes, clearly do go with the LEAPS, not the warrants.

[Sunrider]

I should add - you may now say that maybe I stared with some in options, some in common or cash. On a negative roll I would then take some out of the common or the cash and bring myself up to the starting number of calls again (same net long, perhaps even maintaining the same amount of net leverage).

 

that could probably work .. depending on how many (and how negative) the rolls are and how far BAC rises at the final expiration date, there may even be a scenario where you clearly come out ahead vis-a-vis the warrants (or common or combination thereof).

 

Maybe that's what Eric's planning and maybe he's got a model that gives him a good idea at what points things flip over and one or the other strategy is better.

 

... just thinking ...

 

 

[Studesy]

I should add - you may now say that maybe I stared with some in options, some in common or cash. On a negative roll I would then take some out of the common or the cash and bring myself up to the starting number of calls again (same net long, perhaps even maintaining the same amount of net leverage).

 

that could probably work .. depending on how many (and how negative) the rolls are and how far BAC rises at the final expiration date, there may even be a scenario where you clearly come out ahead vis-a-vis the warrants (or common or combination thereof).

 

Maybe that's what Eric's planning and maybe he's got a model that gives him a good idea at what points things flip over and one or the other strategy is better.

 

... just thinking ...

 

 

You have to look at option #1 (common/leaps) as a 2019 $12 Leap.....it just has to be renewed a few times on the way there (and possibly at a different implied cost of leverage.  Once 2017 comes along you will have two very similar choices to compare.  This is why you can't go wrong investing in the lower cost choice of the two...... implicitly...it is costing you less.

[bobp]

Investmentacct,

 

"Annual volatility 50%"

 

Now, here is the problem with these BAC "A" warrants and it is the implied volatility being at around 53% currently.....

 

There is something bigger at work here and it has to be in the adjustment features that some have mentioned. I imagine that someone (many indeed and algorithms) out there has modeled that using a modified Black Scholes version and that is why there is a premium paid for said warrants.

Cardboard

 

Cardboard, where are you finding the Implied volatility for BAC-WTA?  Ie, are you calculating it or are you getting it from a public website?  Thanks.

 

Not cardboard (not as smart) but here's an implied volatility calculator:

http://www.option-price.com/implied-volatility.php

 

When I calculated BAC b Warrants a few days ago they had an implied vol of about 35%. Citibank A wts were slightly lower around 32%. Neither has the same degree of dividend protection as the BAC a's. So, I think he's right that someone, or some computer program has put a high value on the dividend protection, leading to a higher implied volatility than on C.ws.a , B.ws.b , and the leaps. Whether that's justified or not I don't know.

 

By the way this is some brilliant stuff being posted here by all of you, Eric, Sunrider, Cardboard etc.

 

 

 

 

[Sunrider]

To fan the (mental) flames a bit more - the attached may be interesting for some people to play around with.

 

Whether you believe BS is suitable or not, as long as you believe that the model that drives the price doesn't change from now until later then you can look at changes in price the model produces and draw some conclusions from that (ok, you have to make a few other assumptions, too).

 

Anyway, the attached workbook gives a table for warrant prices given assumed stock prices and dates. You can use the VBA function that comes with the workbook to model other options, too. No guarantee it's correctly implemented though :).

 

by changing the IV at the top you can quickly estimate what the impact of reduced uncertainty is going to be at a certain date. And yes, if it were to come down to 32% or so (where the stock trades) then the impact on the warrant price would be pretty big (as I queried in a post a very long time ago in the BAC thread).

 

... thought I'd quickly throw this together and post it so people in a different time zone can play with it.

 

Cheerio - C.

BAC_-_BS_Warrants_Pricing_Table.xls

[LC]

Sunrider, thanks for that spreadsheet, very interesting!

 

Did you notice if you insert the current IV of 32%, you have to adjust the strike-price of the warrants to $8.75 to achieve the current price per warrant? Seems that the warrants are overvalued by that notion.

[hyten1]

sorry for stupid question what is IV?

 

EDIT: sorry i got it, but why 52.94%?

[Sunrider]

sorry for stupid question what is IV?

 

EDIT: sorry i got it, but why 52.94%?

 

That's what IB currently shows me as the warrant's implied volatility.

 

Yes - if you were to drop the volatility to that of the common you'd see a very large change in price. That's why I said through all this that Eric's got a point in saying that the warrants are expensive (in some sense, not necessarily relative to the options since one can't compare them that easily). So one either has to hope that the implied volatility remains the same or that the stocks appreciates sufficiently by warrant expiration to make up for the inevitable drop in implied volatility.

 

The former could happen simply by there being enough demand for the warrants (or big holders not selling), which could keep the price high (and thus the IV up - IV, in the end, is a measure we back out of the option/warrant price). The latter could happen easily, too. In comparison to the LEAPS though, one has till 2018 for that to happen - i.e. even if it did happen on the very last day you'd be ok, whereas with the LEAPS you'd be losing on the rolls until then.

 

Cheerio - C.

[ERICOPOLY]

I should add - you may now say that maybe I stared with some in options, some in common or cash. On a negative roll I would then take some out of the common or the cash and bring myself up to the starting number of calls again (same net long, perhaps even maintaining the same amount of net leverage).

 

that could probably work .. depending on how many (and how negative) the rolls are and how far BAC rises at the final expiration date, there may even be a scenario where you clearly come out ahead vis-a-vis the warrants (or common or combination thereof).

 

Maybe that's what Eric's planning and maybe he's got a model that gives him a good idea at what points things flip over and one or the other strategy is better.

 

... just thinking ...

 

 

You have to look at option #1 (common/leaps) as a 2019 $12 Leap.....it just has to be renewed a few times on the way there (and possibly at a different implied cost of leverage.  Once 2017 comes along you will have two very similar choices to compare.  This is why you can't go wrong investing in the lower cost choice of the two...... implicitly...it is costing you less.

 

That is the right way to think of what I'm doing -- as a 2019 $12 Leap.

 

It starts out as a combination of 2015 at-the-money LEAPS and the rest in common.  Absolutely no cash remaining.  No money borrowed with margin either.

 

Personally I'm after 1.5x underlying shares of leverage.

 

I could do the exact same strategy by mixing a warrant with common stock (also with no cash left over).

 

People worried what would happen if the market crashes?  Well, that's what I'd want to have happen if my goal is to really embarrass the people who say warrants are better.  You see, if the common is down 50% the $12 LEAPS will be down a lot more than 50% due to skewness.  So I take an opportunity like that to clip a little bit of common (raising cash) and use that cash to roll the 2015s into 2016s -- reconstructing it with 1.5x leverage once again.

 

The skewness helped me get the extra year of leverage at a steep discount.  Even though I had to sell some common at a low price, the option dropped in price a lot more.

 

Or the opposite happens, the stock soars and I trade my 2015 calls for 2016 calls and once again... skewness brings me a bargain price for my extra year of LEAP duration.

 

Then somebody argued with me that I was thinking linearly and that prices might move up and down -- uh huh, sure, I'm the one who is being linear here! 

 

The reason why I initially presented the idea by focusing on the straight-line depreciation decay of the warrant vs LEAPS is that if I talked about all this other fancy footwork I knew the conversation would get too bogged down and I'd get accused of making too many assumptions.

 

So the funny thing is:

1)  stock way up I win on rolling with LEAP vs warrant

2)  stock way down I win on rolling with LEAP vs warrant

3)  stock flat the entire time I don't lose -- I win in fact whenever the bank doesn't pay the "expected" dividend

 

And if I roll the 2015 into the 2016 as soon as it comes out, I protect myself from rolling during a spike in implied volatility (it will be present in both options).

 

Should the company struggle for years and years, that warrant dividend protection premium isn't going to turn out to be all that useful -- so that would hurt the appetite for the warrants (implied volatility drops).  Or if the stock stays low and Moynihan favors buybacks over dividends, that too will hurt the implied volatility!    So you kind of have to be rooting for him to pay dividends instead of buying back shares if you are a warrant holder -- and that's an odd perspective for a value investor to hold when the stock is this low!

 

Yep, that's me -- the linear thinker!

 

 

 

[Studesy]

I should add - you may now say that maybe I stared with some in options, some in common or cash. On a negative roll I would then take some out of the common or the cash and bring myself up to the starting number of calls again (same net long, perhaps even maintaining the same amount of net leverage).

 

that could probably work .. depending on how many (and how negative) the rolls are and how far BAC rises at the final expiration date, there may even be a scenario where you clearly come out ahead vis-a-vis the warrants (or common or combination thereof).

 

Maybe that's what Eric's planning and maybe he's got a model that gives him a good idea at what points things flip over and one or the other strategy is better.

 

... just thinking ...

 

 

You have to look at option #1 (common/leaps) as a 2019 $12 Leap.....it just has to be renewed a few times on the way there (and possibly at a different implied cost of leverage.  Once 2017 comes along you will have two very similar choices to compare.  This is why you can't go wrong investing in the lower cost choice of the two...... implicitly...it is costing you less.

 

That is the right way to think of what I'm doing -- as a 2019 $12 Leap.

 

It starts out as a combination of 2015 at-the-money LEAPS and the rest in common.  Absolutely no cash remaining.  No money borrowed with margin either.

 

Personally I'm after 1.5x underlying shares of leverage.

 

I could do the exact same strategy by mixing a warrant with common stock (also with no cash left over).

 

People worried what would happen if the market crashes?  Well, that's what I'd want to have happen if my goal is to really embarrass the people who say warrants are better.  You see, if the common is down 50% the $12 LEAPS will be down a lot more than 50% due to skewness.  So I take an opportunity like that to clip a little bit of common (raising cash) and use that cash to roll the 2015s into 2016s -- reconstructing it with 1.5x leverage once again.

 

The skewness helped me get the extra year of leverage at a steep discount.  Even though I had to sell some common at a low price, the option dropped in price a lot more.

 

Or the opposite happens, the stock soars and I trade my 2015 calls for 2016 calls and once again... skewness brings me a bargain price for my extra year of LEAP duration.

 

Then somebody argued with me that I was thinking linearly and that prices might move up and down -- uh huh, sure, I'm the one who is being linear here! 

 

The reason why I initially presented the idea by focusing on the straight-line depreciation decay of the warrant vs LEAPS is that if I talked about all this other fancy footwork I knew the conversation would get too bogged down and I'd get accused of making too many assumptions.

 

So the funny thing is:

1)  stock way up I win on rolling with LEAP vs warrant

2)  stock way down I win on rolling with LEAP vs warrant

3)  stock flat the entire time I don't lose -- I win in fact whenever the bank doesn't pay the "expected" dividend

 

And if I roll the 2015 into the 2016 as soon as it comes out, I protect myself from rolling during a spike in implied volatility (it will be present in both options).

 

Should the company struggle for years and years, that warrant dividend protection premium isn't going to turn out to be all that useful -- so that would hurt the appetite for the warrants (implied volatility drops).  Or if the stock stays low and Moynihan favors buybacks over dividends, that too will hurt the implied volatility!    So you kind of have to be rooting for him to pay dividends instead of buying back shares if you are a warrant holder -- and that's an odd perspective for a value investor to hold when the stock is this low!

 

Yep, that's me -- the linear thinker!

 

Makes sense Eric!  So basically when deciding whether or not to buy options or common one needs to compare the "implied cost of leverage" to the expected "implied ROE".  If the latter is significantly higher.....we could consider this an intelligent use of leverage.  By implied ROE I'm saying if a company has a 10% ROE and we purchase it at 0.5x book (equity)...then the implied ROE is 20%.  In the BAC case we happen to have 2 choices or leverage instruments.....may as well choose the cheapest.

[sampr01]

hi eric

Are you using same strategy for AIG-WT vs LEAPS.

 

thanks

[Studesy]

On another note...I believe the same reasoning would stand true when selling covered calls to exit a position which has reached IV.  You would compare the expected "implied ROE" to the "implied return on the leverage"....only in this case you would want the latter to be higher.

[ERICOPOLY]

hi eric

Are you using same strategy for AIG-WT vs LEAPS.

 

thanks

 

I still haven't looked at the AIG comparison  I spent the whole day driving home from Death Valley N.P.