BAC leverage

[ERICOPOLY]

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.

 

Most likely gaining on the rolls (gaining relative advantage to the current price paid upfront for the equivalent year in the warrant). 

 

As the stock moves away (higher or lower) from $12 the cost of rolling the puts (or calls) goes down.

 

The scenario I don't want to have happen is if the stock isn't volatile -- if it just goes flatline on me.  But then again, if that happens it puts the dividend at risk (higher dividends are likely if the stock is higher), as the management and/or Fed would favor buybacks.  A similar thing happened this week as a matter of fact.  And thus, the dividend protection of the warrant is worth less to investors, and thus IV drops.

 

Also, a flatlined stock will keep IV low, so I suppose my cost of rolling LEAPS would go down. 

 

Will the warrant really remain at 50+% IV if the stock is flat for 2-5 years?

[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 ...

 

 

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.

 

 

Hi Eric

 

Well, I wasn't really out to embarrass anyone. Nor have I said that warrants are better.

 

Good luck.

 

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.

 

 

Hi Eric

 

Well, I wasn't really out to embarrass anyone. Nor have I said that warrants are better.

 

Good luck.

 

C.

 

Nor were you the rude one I was thinking of.

[Sunrider]

If I can offer one piece of advice, which you may have thought through already, but others may not have.

 

If you do go with LEAPS in your portfolio (combination, standalone, doesn't matter) and you do intend to roll, then it is likely better for you to do so as soon as the new series is released, assuming the volatility priced into both contracts is roughly similar. The longer you wait, the further the spread will widen between the two LEAP series as the time decay on the near-term option accelerates (it does so faster than that expiring further out). To put some numbers on this - assuming current volatility levels and looking at 2015s vs. 2016s modelled prices,  the spread, assuming BAC stays at 12.59 will be about 52c initially, increasing to about 78c by 1/1/2015. So you can save yourself about 26c (or 10% of the new option price) by rolling early under these assumptions.

 

Of course if the market prices in something strange into both contracts and treats them differently then all bets are off - but none of us can forecast this.

 

Best regards - C.

[Studesy]

 

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

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

[Studesy]

For those interested I have computed the implied leverage costs of the AIG Warrants and a few of the LEAPS (slightly in the money and near the money);

 

AIG Share Price = $38.97

 

 

AIG-WT (expiry=7.83yrs, strike= $45)      Leverage Cost= 8.15%    Break Even with common= $71.97

 

2015 37's (expiry=1.83yrs)                      Leverage Cost= 8.63%    BE= 45.34

 

2015 40's (expiry= 1.83 yrs)                    Leverage Cost= 10.63%      BE= 46.88

 

2015 42's (expiry=1.83yrs)                      Leverage Cost= 12.02%    BE= 47.97

 

 

[compoundinglife]

Nor were you the rude one I was thinking of.

 

I hope my comment/thoughts about market crash or systematic events did not come across as rude, that was not my intention.

 

Just trying to think outside the box in terms of how the trade could blow up, you know take care of the downside and the upside will take care of itself. Barring some crazy worldwide meltdown that prevents rolling over (which I agree is out there :) ), it seems like the major things are:

 

1. Being mentally defeated from a price collapse and you do not stick to the roll over plan. Need to know yourself and how you react to these things. 

2. Not having the resources to roll over because you did not adhere to keeping the cash or common around.

3. The market screws you over through enough roll over periods that you no longer have the capital to continue (which is not specific to this strategy, you would get owned here with the warrants as well).

 

[racemize]

For those interested I have computed the implied leverage costs of the AIG Warrants and a few of the LEAPS (slightly in the money and near the money);

 

AIG Share Price = $38.97

 

 

AIG-WT (expiry=7.83yrs, strike= $45)      Leverage Cost= 8.15%    Break Even with common= $71.97

 

2015 37's (expiry=1.83yrs)                      Leverage Cost= 8.63%    BE= 45.34

 

2015 40's (expiry= 1.83 yrs)                    Leverage Cost= 10.63%      BE= 46.88

 

2015 42's (expiry=1.83yrs)                      Leverage Cost= 12.02%    BE= 47.97

 

Thanks!  That's an easy decision...

[racemize]

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

+1. This is important for how the cost works out on more negative common stock movements, so I am also very interested.

[Sunrider]

Well, since this is - in some sense - a piggy bank strategy (keep some money in, say, cash to be able to roll even in bad scenarios OR keep some money in common to have a chance to roll in bad scenarios and some participation of upside) I'd say the following:

 

If the market falls significantly and you're still convinced the stock will hit your price target by the next roll point (or before) then stick with the original strike and buy more of it (increase leverage).

 

If it falls significantly and you think there may be another roll cycle that doesn't work out favourably before getting better, then I'd say stay the course, maintain the same level of leverage (which you can do with the previous strike or more of a lower strike but more expensive option).

 

I think ...

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

+1. This important for how the cost works out on more negative common stock movements, so I am also very interested.

[Sunrider]

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

[ERICOPOLY]

Nor were you the rude one I was thinking of.

 

I hope my comment/thoughts about market crash or systematic events did not come across as rude, that was not my intention.

 

Just trying to think outside the box in terms of how the trade could blow up, you know take care of the downside and the upside will take care of itself. Barring some crazy worldwide meltdown that prevents rolling over (which I agree is out there :) ), it seems like the major things are:

 

1. Being mentally defeated from a price collapse and you do not stick to the roll over plan. Need to know yourself and how you react to these things. 

2. Not having the resources to roll over because you did not adhere to keeping the cash or common around.

3. The market screws you over through enough roll over periods that you no longer have the capital to continue (which is not specific to this strategy, you would get owned here with the warrants as well).

 

 

No, that isn't rude either.

 

It's the people who posted on here about how silly the discussion is.

 

Get a life folks!  If people are having a discussion on the internet it's not your place to call their discussion a silly one.  The place for trolls is under the bridge.

 

Given that we've already decided to use leverage (the title is "BAC Leverage"), what's silly about discussing the various options!

[ERICOPOLY]

 

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

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

 

 

 

 

 

 

 

 

[Studesy]

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

I don't think the volatility is important here.  What we have to be concerned with is the accuracy in our analysis of the underlying BAC common.  Given that this is correct and we wish to use leverage via LEAPS or warrants......it makes the most sense to stick with the cheaper form of leverage.

[Studesy]

 

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

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

[Sunrider]

Hi Studesy

 

That's not what I was trying to get at. I was merely making a comparative statement about the pricing of two related instruments in the market and whether the one seems to be priced fairly when taking the other as the reference without assuming anything about price movement. Call it a finance theory discussion - little bearing on the debate of what instrument to use (and none if you're certain that BAC will be above, say, 16 by 2015).

 

Cheers - C.

 

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

I don't think the volatility is important here.  What we have to be concerned with is the accuracy in our analysis of the underlying BAC common.  Given that this is correct and we wish to use leverage via LEAPS or warrants......it makes the most sense to stick with the cheaper form of leverage.

[yitech]

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

It's option value, not IV that is proportional to the square root of time for the same strike prices when IV's are the same. You can simply compare Jan '14 and '15 and see if this is roughly true. Of course the IVs between options with different expirations are usually different(time skew), but if they were exactly the same, option values ought to be proportional to the square root of time.

[ERICOPOLY]

 

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

 

 

 

Eric...What is your reasoning behind using 1.5x leverage as opposed to a higher or lower amount. Or is this just pure personal preference based on the cost of that leverage and the upside you believe BAC has.

 

Also, in the case we see a decline in BACs share price before the 2015 LEAPS are rolled into 2016's...would you roll into 2016 $12's or would you use a lower slightly in the money LEAP? Thanks again BTW.

 

 

1.5x leverage is just personal choice.  No formula.  The leverage was higher when the upside was greater. 

 

Not sure what strike I'll roll into if the share price declines significantly.

 

By the same token, I might roll into a $17 strike calls in 2015.

 

The trouble with the warrants is that you're stuck with that deep-in-the-money put the entire time (it ought to be deep-in-the-money in the later years, like when the stock is above $20).

 

What if, as the stock advances, I keep moving up the strikes to at-the-money every single time I roll my calls?  All I need to do is hedge the amount of money that I initially "borrowed".  So I would be purchasing fewer and fewer contracts as the price rises, and as the uncertainty is lifted in the stock (along with the rising price) I'll probably still be paying decreasing financing costs (as IV declines).

 

Okay, so now it's 5 years from today, my strikes have been moved up to $25 as I roll my LEAPS,  and now the stock crashes all the way back to $10 due to a systemic event worse than 2009.

 

What say you now warrant lovers!  ;) Is that worst case scenario something you have planned for?  Perhaps you want to rethink again what a "worst case" scenario looks like, eh?

 

So as the pice of the underlying has increased (more risk) you have decreased your leverage(as well as shopped for the cheapest leverage).  At what point along this risk spectrum do you see it necessary to hedge? Also,how much of the 1.5x leverage position do you hedge out and a what price?

 

Let's say the stock is at $25 and I am rolling my calls.  I figure how much I'm levered at the time, and purchase puts to hedge only the leverage (keeping it non-recourse leverage).

 

The warrant guy can't do this -- he is stuck in that $13.30 straight-jacket.  And that warrant put will be about as comforting as a wet blanket when the stock is at $25.

 

Look at what a "clear sailing" put sells for on a bank -- Wells Fargo puts cost something like 5% annualized for at-the-money.

 

So even though I may be hedging at-the-money when I roll my LEAPS as the stock rises for BAC,  I might very well still be (and likely will be!) benefitting from declining financing costs for my leverage.

 

So not only are people paying a dear price for the put in the warrants, they'll likely come to find that it brings them no comfort when people start worrying about the next crisis as it gets near expiry.

 

 

[racemize]

Hi Studesy

 

That's not what I was trying to get at. I was merely making a comparative statement about the pricing of two related instruments in the market and whether the one seems to be priced fairly when taking the other as the reference without assuming anything about price movement. Call it a finance theory discussion - little bearing on the debate of what instrument to use (and none if you're certain that BAC will be above, say, 16 by 2015).

 

This is what I've been trying to resolve myself, but I don't know how to price the rolls correctly.  I was trying to create a spreadsheet where you could type in the common prices each year and compare the cost of rolls/return to the cost/return of warrants.  Assuming Eric is correct, the leaps should always be better, but I'd like to verify with some numbers.

[Sunrider]

Ermm - with respect, but doesn't that come to the same thing. I'm comparing vol and say it must change with sqrt(t). You're saying, keep vol the same and compare across maturity and you should see the relationship in price (i.e. price changing with sqrt(t). So I'd kinda expect that intuitively since you priced in the same volatility you have to see the price move and we don't expect that price move to be linear because the formula assume a non-linear relationship to volatility ... hope I'm making sense here.

 

C.

 

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

It's option value, not IV that is proportional to the square root of time for the same strike prices when IV's are the same. You can simply compare Jan '14 and '15 and see if this is roughly true. Of course the IVs between options with different expirations are usually different(time skew), but if they were exactly the same, option values ought to be proportional to the square root of time.

[Sunrider]

Hi racemize

 

Note please, that my question/argument above, does not mean that LEAPS Rolls should be considered as equivalent to warrants or that I'm saying that, in fact, there is the same cost of leverage (as Eric defines it: clearly not). All this says is (if I'm right) that under the usual assumptions (no arbitrage, efficiency, yada yada), they are priced fairly in relation to each other.

 

If you have a view on where the stock will end up at a certain date, you can very well come to the conclusion that one is overvalued vs. the other (as Eric has done). That's kinda the conclusion of this thread - if you don't have a view on what will happen from now until 2018 but you do believe that BAC will be worth more than 13.30+5.6, then the warrants and rolling LEAPS strategies seem to be priced the same now (that's sort of an 'expectations' statement - i.e. across all possible scenarios and paths, fixing only the end-point, so covering a range of scenarios in which the rolls don't work out so well.

 

Note further that this does not speak to the piggy bank strategy of buying LEAPS and financing changes in the rolls from sales of common.

 

Cheers - C.

 

 

Hi Studesy

 

That's not what I was trying to get at. I was merely making a comparative statement about the pricing of two related instruments in the market and whether the one seems to be priced fairly when taking the other as the reference without assuming anything about price movement. Call it a finance theory discussion - little bearing on the debate of what instrument to use (and none if you're certain that BAC will be above, say, 16 by 2015).

 

This is what I've been trying to resolve myself, but I don't know how to price the rolls correctly.  I was trying to create a spreadsheet where you could type in the common prices each year and compare the cost of rolls/return to the cost/return of warrants.  Assuming Eric is correct, the leaps should always be better, but I'd like to verify with some numbers.

[yitech]

Ermm - with respect, but doesn't that come to the same thing. I'm comparing vol and say it must change with sqrt(t). You're saying, keep vol the same and compare across maturity and you should see the relationship in price (i.e. price changing with sqrt(t). So I'd kinda expect that intuitively since you priced in the same volatility you have to see the price move and we don't expect that price move to be linear because the formula assume a non-linear relationship to volatility ... hope I'm making sense here.

 

C.

 

There's one thing that has been bothering me in this cost of leverage debate and this probably comes back to the linearity question.

 

In theory - whether you agree with the model or not - the LEAPS and the warrants likely are priced based on similar assumptions by the market. If so, and one crucial assumption being volatility, then we should be able to compare what you're paying for in the rolls to what you're paying for in the warrants. This is similar to the 'loose on every roll until you win on the last one scenario'.

 

I haven't thought this through properly and wanted to offer it for debate. Maybe Hielko can chime in.

 

Volatility, if I remember correctly, moves withe the sqrt of time so with 2015 12 calls at about 34.5% IV at the moment have 1.9 years to go. Warrants have 5.92 years to go. So the warrants have 5.29/1.99 = 2.66 times more time. Assuming the LEAP's IV is fair, we would expect an option with 2.66x more time to price at IV of 34.5% x sqrt(2.66) = 56%.

 

Hielko or anyone else that remembers their finance classes - is that correct? If so, then without making any assumptions on price path, eventual pay-off, etc. we can say that the warrants are not particularly cheap or expensive vis-a-vis the reference LEAPS, right?

 

Cheers - C.

 

It's option value, not IV that is proportional to the square root of time for the same strike prices when IV's are the same. You can simply compare Jan '14 and '15 and see if this is roughly true. Of course the IVs between options with different expirations are usually different(time skew), but if they were exactly the same, option values ought to be proportional to the square root of time.

 

I simply state the option math and that you can't multiply IV by square root of time to get an estimate of another IV. If an option with one month to expire have a vol of 30%, by your logic, a 6 year vol would be 30%*sqrt(72)=254%, making the BAC A warrant seem like an incredible bargain. Does that make sense?

[racemize]

Incidentally, JPM warrants only have a 5.66% cost of leverage--this seems quite low (one of the lowest of the warrants in my spreadsheet).

[plato1976]

May I know how to calculate this cost of leverage ?

I have some AIG warrants and never calculated this cost of leverage ...

 

Incidentally, JPM warrants only have a 5.66% cost of leverage--this seems quite low (one of the lowest of the warrants in my spreadsheet).

[ERICOPOLY]

I was trying to create a spreadsheet where you could type in the common prices each year and compare the cost of rolls/return to the cost/return of warrants.  Assuming Eric is correct, the leaps should always be better, but I'd like to verify with some numbers.

 

 

It's also not an apples-to-apples comparison.

 

The LEAPS strategy, if I roll to at-the-money strikes is a safer strategy.  At every roll I lock in my gains as the price rises.

 

The Warrants strategy -- the put never moves.  It never gets higher than 13.30.

 

So in this sense, the LEAPS strategy is not only less risky (locking in gains as they come), but potentially lower cost as well.

 

We then are not merely arguing about price here -- it's also about the underlying value of a strategy with a rising put strike versus a static one.

 

Risk adjusted, I'll take the rising put strike strategy even if it works out to have no cost advantage.