BAC leverage

[Studesy]

Hmm - but if I understood this correctly, the whole strategy is predicated on the fact that you are 100% certain that BAC will be much higher in 2018 than it is today (say above 24 or whatever the 'switch over' point is). So if that's the case you truly should not care about the non-recourse nature and simply go for the cheapest leverage?

 

Thanks - C.

 

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

 

I think the options are used because they provide non recourse leverage. Would be the equivalent of borrowing to buy the additional 500 shares and then buy put options to protect a certain amount of downside. That's what Eric was talking about the embedded put in the leaps.

 

I don't think anyone can be 100% certain of that.

[maxprogram]

Just skimming this thread and going back here, so forgive me if I missed something.

 

How is the cost of leverage being calculated for calls? In the example below, shouldn't leverage cost decrease with increasing strike prices? (i.e. you are "borrowing" more money, with a lower cost.)

 

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

[hyten1]

max here is an example of how you calculate the leverage cost

 

take jan 2015 call strike of $12

 

strike = $12

premium = $2.72

breakeven = 12 + 2.72 = 14.72

 

$12 - 2.72 = $9.28

 

the leverage cost is the rate that will grow $9.28 to $12 in 2 yrs (since this jan 2015 call, approx 2 years from now).

 

that is general idea

 

[gokou3]

Makes sense.  Unfortunately in Canadian registered accounts we can't do that.  Can only buy puts & calls.....can only sell covered calls.  Cana anyone else from Canada verify that I am correct on this?

 

That's my experience with my BMO RSP account too.

[Sunrider]

Yes - but you're after the lowest cost of leverage, so keep some money in reserve and fill the margin call if you have to. That's basically the approach Eric outlined with keeping some in common/cash. However, note that at this low leverage that Eric was describing the margin call is fairly unlikely anyway.

 

sunrider

 

what about margin calls as the stock swing?

 

if you borrow on margin, the stock drops, trigger margin call you would be force to sell to cover margins

 

option doesn't have that problem (this is when non recourse helps)

 

i think?

 

hy

[Sunrider]

Erm yes - see the rest of the thread - depending on how certain you are, choose more or less leverage. Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point because he expects the stock to have appreciated markedly. He got to that in a somewhat novel way through his cost of leverage. So all I'm saying is that: given these assumptions, the starting point, etc. the above (take some cash, lever it with a cheap margin loan and fill the margin call if you have to) should be the cheaper option.

 

By the way margin call = loss on Eric's option roll, methinks. The examples of non-recourse finance = mortgage in the other thread would back this up: don't satisfy your margin call, lose your equity. Only that you'd probably want to satisfy some of the margin call, to maintain the desired level of leverage. That would be the equivalent to him rolling options - in the worst case having a full loss on the options - and then using the money kept on the side to buy options again.

 

Eric - what's your view here? Are we missing anything that throws this out?

 

Thanks - C.

 

Hmm - but if I understood this correctly, the whole strategy is predicated on the fact that you are 100% certain that BAC will be much higher in 2018 than it is today (say above 24 or whatever the 'switch over' point is). So if that's the case you truly should not care about the non-recourse nature and simply go for the cheapest leverage?

 

Thanks - C.

 

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

 

I think the options are used because they provide non recourse leverage. Would be the equivalent of borrowing to buy the additional 500 shares and then buy put options to protect a certain amount of downside. That's what Eric was talking about the embedded put in the leaps.

 

I don't think anyone can be 100% certain of that.

[value-is-what-you-get]

Makes sense.  Unfortunately in Canadian registered accounts we can't do that.  Can only buy puts & calls.....can only sell covered calls.  Cana anyone else from Canada verify that I am correct on this?

 

That's my experience with my BMO RSP account too.

 

Yes this is correct by my experience and I ve never understood why we can buy a put option and not sell one provided there is enough cash to cover if assigned.  Now I haven't ever exercised a put in my registered acct.    If it is not possible to exercise a put then it sort of redefines what a put option is in a registered account.

[ERICOPOLY]

Erm yes - see the rest of the thread - depending on how certain you are, choose more or less leverage. Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point

 

Let me clear up a misconception....

 

"Optionality" ranks in this order (from lowest to highest):

 

1)  Common  (least optionality)

2)  Warrants (more optionality)

3)  LEAPS (most optionality)

 

You get more and more optionality when you shorten the maturity date of the option.

 

 

[ERICOPOLY]

Erm yes - see the rest of the thread - depending on how certain you are, choose more or less leverage. Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point because he expects the stock to have appreciated markedly. He got to that in a somewhat novel way through his cost of leverage. So all I'm saying is that: given these assumptions, the starting point, etc. the above (take some cash, lever it with a cheap margin loan and fill the margin call if you have to) should be the cheaper option.

 

By the way margin call = loss on Eric's option roll, methinks. The examples of non-recourse finance = mortgage in the other thread would back this up: don't satisfy your margin call, lose your equity. Only that you'd probably want to satisfy some of the margin call, to maintain the desired level of leverage. That would be the equivalent to him rolling options - in the worst case having a full loss on the options - and then using the money kept on the side to buy options again.

 

Eric - what's your view here? Are we missing anything that throws this out?

 

Thanks - C.

 

 

BAC is trading below tangible book and capable of earning 13+% on tangible book.  I'm burning 10% a year waiting for that to be reflected in the stock.  One day it will.  In two years?  I don't know.  But that's the proposition -- one day it will.

 

There is no 100% certainty of anything.  There is no risk of a margin call with my strategy.

[ERICOPOLY]

Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point because he expects the stock to have appreciated markedly.

 

 

Let me remind you of one possible worst case scenario.

 

The stock goes up like I expect, it's even up to $30 in late 2018, but then (just like Wells Fargo in early 2009), it crashes from $30 down to $8 over a span of three months and you lose 100% of what you invested in the warrant.

 

Me?  I'll be sitting on a massive gain... and keeping it.  That's because I lock my gains in as I go, on every success roll of the LEAPS.

 

Once again... the warrants are risking 100% loss because you are locked in that $13.30 strike straightjacket.

 

Got it now???

 

My strategy is less risky.

 

And I happen to think it will also be cheaper.

 

Because the LEAPS are of less duration to maturity, and I have multiple rolls where I lock in gains, they have more optionality.

[ERICOPOLY]

I believe if the stock stays at $12 the entire time, never up nor down, the two strategies will roughly break even with each other.

 

However, I believe mine will win if I can do a roll when the stock is depressed far below $12 (due to "skewness").

 

And if I ever roll at-the-money at a higher strike, then I'll most certainty win from a risk-adjusted standpoint (because I will have not lost that amount of option premium, it's no longer left on the table anymore).

 

Suppose for example I roll into the 2016 call when the stock is at the money on a $14 strike.  Then $2 of my initial capital outlay can not be lost for the whole rest of the time.  It is now "locked in". 

 

You are never locking anything in with the warrant.  It's all or nothing, baby.

 

[LC]

I can purchase Nov 2013 puts on BAC (to ensure they expire this year) and finance them with Jan 2014 puts on other things (maybe SHLD).

 

Later, when the Dec 2013 puts on BAC come out, I'll roll the Nov puts into the Dec puts.  I'm pretty sure they'll issue the series that ends on Dec 31st, like they always do.

 

That way, I can then close out the SHLD puts at market open on the first trading day of 2014.

 

I (expect to) take the losses on the BAC puts in 2013, and the gains on the SHLD puts in 2014.

 

Given the large amount of short-term capital gains I just booked from selling my BAC warrants, I can use a good tax write-off.

 

The SHLD puts I write will be short-term gains as well, but I push them out a year (okay, a couple of days) where my tax bracket might be lower.  And if I do this every year, I might never pay those taxes.

 

 

EDIT:  Yes, there is a risk of crash at market open in 2014.  So, a bit more than a month before the BAC puts expire, I purchase a new series of them.  Then after the SHLD puts expire I write more (to finance the BAC puts purchased in November).  That way there is a lock protecting the window of time over the New Year holiday. 

 

Question:  Is it necessary to purchase the 2014 BAC puts a full month before those 2013 BAC puts expire?  I'm doing it that way because I presume otherwise there would be a wash sale rule problem with not using those losses in 2013.

Can't you theoretically defer taxes forever with this technique?

[LC]

I believe if the stock stays at $12 the entire time, never up nor down, the two strategies will roughly break even with each other.

 

However, I believe mine will win if I can do a roll when the stock is depressed far below $12 (due to "skewness").

 

And if I ever roll at-the-money at a higher strike, then I'll most certainty win (because I will have not lost that amount of option premium).

 

Suppose for example I roll into the 2016 call when the stock is at the money on a $14 strike.  Then $2 of my initial capital outlay can not be lost for the whole rest of the time.  It is now "locked in". 

 

You are never locking anything in with the warrant.  It's all or nothing, baby.

You lock in gains with the warrant as you sell them. Let's say the stock is at $30 in late 2018 and you simply sell your warrants rather  than hold until expiration. Gains locked in. Let's remember this is that this is a value investing forum...when an undervalued stock becomes fairly valued, it can be sold :)

 

You can also sell a proportion of the warrants you hold at various points from now and 2019 to "lock in" gains along the way. 

 

Now, the warrants still imply a higher cost as you have shown, and the options offer more chances to adjust the strategy due to the rollovers of the contracts, so I believe the LEAP strategy is still superior. I still hold a bunch of warrants though, lol.

[ERICOPOLY]

I can purchase Nov 2013 puts on BAC (to ensure they expire this year) and finance them with Jan 2014 puts on other things (maybe SHLD).

 

Later, when the Dec 2013 puts on BAC come out, I'll roll the Nov puts into the Dec puts.  I'm pretty sure they'll issue the series that ends on Dec 31st, like they always do.

 

That way, I can then close out the SHLD puts at market open on the first trading day of 2014.

 

I (expect to) take the losses on the BAC puts in 2013, and the gains on the SHLD puts in 2014.

 

Given the large amount of short-term capital gains I just booked from selling my BAC warrants, I can use a good tax write-off.

 

The SHLD puts I write will be short-term gains as well, but I push them out a year (okay, a couple of days) where my tax bracket might be lower.  And if I do this every year, I might never pay those taxes.

 

 

EDIT:  Yes, there is a risk of crash at market open in 2014.  So, a bit more than a month before the BAC puts expire, I purchase a new series of them.  Then after the SHLD puts expire I write more (to finance the BAC puts purchased in November).  That way there is a lock protecting the window of time over the New Year holiday. 

 

Question:  Is it necessary to purchase the 2014 BAC puts a full month before those 2013 BAC puts expire?  I'm doing it that way because I presume otherwise there would be a wash sale rule problem with not using those losses in 2013.

Can't you theoretically defer taxes forever with this technique?

 

I don't see why not.

[ERICOPOLY]

You lock in gains with the warrant as you sell them. Let's say the stock is at $30 in late 2018 and you simply sell your warrants rather  than hold until expiration. Gains locked in. Let's remember this is that this is a value investing forum...when an undervalued stock becomes fairly valued, it can be sold :)

 

Let's say then that I succeed in rolling into at-the-money LEAPS when the stock hits $20, but you were holding out for $30 with your warrants.

 

Then the crash happens.

 

Now you lose with the warrants.  Possibly not everything you put into it, but remember I'm locked in at $20 strike (with $8 safely taken off the table) and you are at $13.30 strike.

 

You only have one chance to pull the trigger on your gains.  I will be locking in whatever gains are there once a year.

 

 

 

[ERICOPOLY]

Or that same scenario happens a year from now after I roll at $16, and then the crash happens.

 

Maybe I'm rolling back into it at $10 on the next roll.

 

I've got $4 taken off the table, and I'm getting back in at $10 strike now.

 

[LC]

You lock in gains with the warrant as you sell them. Let's say the stock is at $30 in late 2018 and you simply sell your warrants rather  than hold until expiration. Gains locked in. Let's remember this is that this is a value investing forum...when an undervalued stock becomes fairly valued, it can be sold :)

 

Let's say then that I succeed in rolling into at-the-money LEAPS when the stock hits $20, but you were holding out for $30 with your warrants.

 

Then the crash happens.

 

Now you lose with the warrants.  Possibly not everything you put into it, but remember I'm locked in at $20 strike (with $8 safely taken off the table) and you are at $13.30 strike.

 

You only have one chance to pull the trigger on your gains.  I will be locking in whatever gains are there once a year.

 

Yep, you're right. The warrant holder would have to be trimming their position to solidify some gains. Whereas the LEAP holder can simply take gains off the table by rolling over into a higher strike-price. Good freakin thinking, man.

 

And you only are only exposed during a two-year (or one year given the new LEAP issues) window to a loss. I.e. as the stock tanks, you can roll into the next issue of LEAPs at a lower strike price for a lower cost. Yep, good freaking thinking...

[racemize]

Or that same scenario happens a year from now after I roll at $16, and then the crash happens.

 

Maybe I'm rolling back into it at $10 on the next roll.

 

I've got $4 taken off the table, and I'm getting back in at $10 strike now.

 

Stupid question (maybe), where are you putting the gains on your rolls as you do this, back in common?

[hyten1]

sunrider

 

I think the risk profile btw margin vs option are just not the same (also one is non-recourse the other isn't).

 

with the option strategy if you want 1.5x leverage the inital capital outlay is lower vs the margin method.

 

for example lets say you want to put $100k into BAC, to get to 1.5x leverage using margin you will have to borrow 50k at let say 2% or whatever (you say you leave some cash behind etc to cover the cost if margin call happens) that means you will need more than 100k, how much do you leave behind? 10k? 20k? 30k?, 40k? to cover potential margin call and interest payment.

 

with an option strategy it cleaner and simplier you buy 100k of BAC, lets say that gets you 10k shares (at $10 per share) you will then need (lets say the call you want to buy is at $2 a share) additional $2 x 5k shares = $10k. That is it.

 

i guess i just don't see how the margin way would be better? you say because it has 2% interest? but you are borrowing 50k. also its recourse, so you say you leave some money behind? that is additional capital (opportunity cost).

 

also for me it is not just finding the lower leverage cost, other factors come into play as well (non recourse, capital allot for it etc etc). honestly as for the exact levearge cost btw the 2 i have no computed.

 

i hope i didn't misunderstood what you meant?

 

hy

 

 

Erm yes - see the rest of the thread - depending on how certain you are, choose more or less leverage. Eric's point was in the first place that you'd be silly to pay up for optionality past the first year point because he expects the stock to have appreciated markedly. He got to that in a somewhat novel way through his cost of leverage. So all I'm saying is that: given these assumptions, the starting point, etc. the above (take some cash, lever it with a cheap margin loan and fill the margin call if you have to) should be the cheaper option.

 

By the way margin call = loss on Eric's option roll, methinks. The examples of non-recourse finance = mortgage in the other thread would back this up: don't satisfy your margin call, lose your equity. Only that you'd probably want to satisfy some of the margin call, to maintain the desired level of leverage. That would be the equivalent to him rolling options - in the worst case having a full loss on the options - and then using the money kept on the side to buy options again.

 

Eric - what's your view here? Are we missing anything that throws this out?

 

Thanks - C.

 

Hmm - but if I understood this correctly, the whole strategy is predicated on the fact that you are 100% certain that BAC will be much higher in 2018 than it is today (say above 24 or whatever the 'switch over' point is). So if that's the case you truly should not care about the non-recourse nature and simply go for the cheapest leverage?

 

Thanks - C.

 

Hi Eric

 

Please also see my question re clarification in the other thread (General board).

 

I'm still struggling to fully follow your reasoning (not with respect to what you consider cheap or expensive, that's fairly clear) but if I go back right to the beginning you said you're simply looking for the lowest cost of leverage.

 

If that is so, then why are you using options at all? Why not just buy 150 worth of shares for every 100 you actually want to invest (or the same on share numbers) and get IB to finance that leverage for you at about 1.something%? Wouldn't a margin loan always be below the 9% or similar your calculation would yield on pretty much any option (I think so because in the option you're paying for uncertainty, with the margin loan you're not really).

 

Thanks - C.

 

I think the options are used because they provide non recourse leverage. Would be the equivalent of borrowing to buy the additional 500 shares and then buy put options to protect a certain amount of downside. That's what Eric was talking about the embedded put in the leaps.

 

I don't think anyone can be 100% certain of that.

[ERICOPOLY]

Or that same scenario happens a year from now after I roll at $16, and then the crash happens.

 

Maybe I'm rolling back into it at $10 on the next roll.

 

I've got $4 taken off the table, and I'm getting back in at $10 strike now.

 

Stupid question (maybe), where are you putting the gains on your rolls as you do this, back in common?

 

Yes, back in common.

 

So if the stock is double where it is today, I'll have 1.25x upside and 1x downside.

 

I'm just buying a hedge that protects the amount initially borrowed, leaving any gains on the table.

 

[ERICOPOLY]

Yes - but you're after the lowest cost of leverage, so keep some money in reserve and fill the margin call if you have to. That's basically the approach Eric outlined with keeping some in common/cash. However, note that at this low leverage that Eric was describing the margin call is fairly unlikely anyway.

 

I'm not after the lowest cost of leverage.

 

I'm after the lowest cost of non-recourse leverage.

 

Margin leverage, unhedged, is not in the cards for me.

 

This entire discussion is about comparing a 6 year warrant to a 2 year LEAPS.  They have different pros and cons, and for the life of me I can't put that many "pros" in the warrant column given it's annualized cost of leverage. 

 

I've seen a lot of people post on this board about how they hold their BAC position as mostly common, and a few warrants mixed in.  Thus, I think they already are not trying to leverage to the max.  I'm just trying to explain that for what they want (a little bit of leverage), there seems to be a way of getting much more advantage (like rolling to higher strikes), while quite likely spending a lot less for the cost of leverage at the same time.

[ERICOPOLY]

Makes sense.  Unfortunately in Canadian registered accounts we can't do that.  Can only buy puts & calls.....can only sell covered calls.  Cana anyone else from Canada verify that I am correct on this?

 

That's my experience with my BMO RSP account too.

 

 

Then you guys can participate:

 

Example

1)  Buy SHLD common (take SHLD downside)

2)  Write SHLD covered call (collect premium)

3)  Buy BAC call with premium from step 2

 

 

 

[ERICOPOLY]

so if you think there is going to be some catalyst that moves the stock before the call matures and in relatively short order, you would want the higher strike calls... i think.

 

I believe in that case it would be worth paying a higher annualized cost of leverage for a very short term call with at-the-money strike.

 

Then:

1)  you suffer less absolute dollar loss due to skewness

2)  you can then roll to lock in gains if you think the stock still has a lot more appreciation left in it

[ERICOPOLY]

so if you think there is going to be some catalyst that moves the stock before the call matures and in relatively short order, you would want the higher strike calls... i think.

 

I believe in that case it would be worth paying a higher annualized cost of leverage for a very short term call with at-the-money strike.

 

Then:

1)  you suffer less absolute dollar loss due to skewness

2)  you can then roll to lock in gains if you think the stock still has a lot more appreciation left in it

 

 

And note that I pointed out the assumption of a higher annualized cost of leverage for the shorter term option?

 

This is what this discussion all boils down to.

 

You are getting lots of benefits from shorter term options (multiple rolls to lock in gains and less absolute dollar loss from skewness on major stock moves).

 

You should therefore be paying a higher cost of leverage (get what you pay for).

 

Thus, why am I finding the LEAPS priced at similar cost of leverage to the Warrants?  The LEAPS have so much advantage, they should be the one with the more expensive annualized leverage cost.  Not the warrants!

 

 

[hyten1]

eric i hear ya, definitely if you think some short term catalyst is going to move the stock then short term call will have the largest movement.

 

what about for jan 2015 calls? comparning btw 7,10,12 strikes. i have notice the 12 strikes price movement has been larger recently relative to the 10s and 7s.

 

hy

 

so if you think there is going to be some catalyst that moves the stock before the call matures and in relatively short order, you would want the higher strike calls... i think.

 

I believe in that case it would be worth paying a higher annualized cost of leverage for a very short term call with at-the-money strike.

 

Then:

1)  you suffer less absolute dollar loss due to skewness

2)  you can then roll to lock in gains if you think the stock still has a lot more appreciation left in it