BAC leverage

[ERICOPOLY]

Eric, I'm very close to having a spreadsheet that models what your strategy is (I think anyway), so that I can compare it to the warrants under various scenarios.  But, from your replies, I'm a little unsure how you deal with a some situations:

 

Let's say you have an initial leverage of 1.2. 

 

Scenario 1-stock goes up:

You've said that if the stock price goes up, the leverage will go down, e.g., to 1.15.  In that case, I believe you said you would keep the leverage at 1.15 instead of 1.2 on the roll.  Accordingly, that will mean that with the gains you would buy some common and a lesser #of options on the roll, correct?

 

Scenario 2-stock goes down:

If the stock goes down, would you hold the leverage at 1.2, or would you increase it? 

 

 

So, did I get scenario 1 right, and what happens in scenario 2?

 

Sorry, I never saw this reply of yours -- but when the thread got bumped today, I just noticed it.

 

For scenario 1, it means there will be the same number of underlying shares but fewer of them are hedged.  So that would mean taking delivery on a portion of calls, and rolling the rest.  For my margin account (portfolio margin), it means taking delivery on all of them and buying puts on just the right amount in order to keep the margin loan hedged.

 

For scenario 2, that depends.  May or may not.  I might benefit merely from the lower cost of rolling (due to skewness), or I might choose to increase leverage.  Or might choose a lower strike price when I roll.  Not sure what I'd do, but lots of flexibility available.

 

[Mephistopheles]

Eric, since you squashed the misconception that the warrants are safer than the LEAPS because they are longer duration, I naturally wonder - why not buy even shorter term options and roll over with the same strategy in mind? If we maintain the same leverage ratio and the cost of leverage is maybe even cheaper, wouldn't that be an even more profitable trade (transaction costs and taxes excluded)?

[Rabbitisrich]

Eric, since you squashed the misconception that the warrants are safer than the LEAPS because they are longer duration

 

How do you figure this? Can you paraphrase or direct me to the argument?

[ERICOPOLY]

I naturally wonder - why not buy even shorter term options and roll over with the same strategy in mind?

 

Normally the options are priced such that on a straight-line depreciation basis the longer term ones have cheaper annualized cost of leverage.

 

Your proposal would work if the market price of the stock made a large movement, but it would be inferior if the stock price were completely flat.  This explains why more volatile stocks have more expensive options.

 

 

[ERICOPOLY]

Eric, since you squashed the misconception that the warrants are safer than the LEAPS because they are longer duration

 

How do you figure this? Can you paraphrase or direct me to the argument?

 

Here is one of the arguments, and perhaps the strongest:

 

1)  The most likely scenario being that the stock goes up over time.... 

2)  The puts in the LEAPS strategy can get rolled to higher strikes.

3)  Stock price crashes and your puts are at higher strike.

 

There it is.

 

Meanwhile, all along you had less money on the table.  Less at risk, safer strategy...  what's not to love?

[Rabbitisrich]

 

 

Here is one of the arguments, and perhaps the strongest:

 

1)  The most likely scenario being that the stock goes up over time.... 

2)  The puts in the LEAPS strategy can get rolled to higher strikes.

3)  Stock price crashes and your puts are at higher strike.

 

There it is.

 

Meanwhile, all along you had less money on the table.  Less at risk, safer strategy...  what's not to love?

 

Thank you, that looks reasonable. Although, perhaps Mephistopheles had a separate argument comparing instrument to instrument? The leaps rollover plan is better compared to a warrant plus ITM puts plan. The capital gains deferral is the other major benefit in exchange for more downside exposure.

[ERICOPOLY]

The capital gains deferral is the other major benefit in exchange for more downside exposure.

 

 

The way to get around the capital gains deferral issue is to (instead of using calls) buy the extra common using margin loan and hedge the size of the loan with LEAPS puts.  Just make sure it's a "portfolio margin" account instead of a "Reg-T margin" account.

 

This way you will most likely have eliminated the problem of taxation when rolling.

 

You also capture all of the dividend -- so certainly there is no longer any sort of paranoia about missing out on it.

 

Interactive Brokers has really cheap margin rates.  I pay less than 1% annualized margin interest rate.

 

Here is what I wrote to racemize in private mail a few days ago:

I looked up the cost of the $12 strike put that expires in 2015.

 

$2.04 is the "ask" -- roughly 10% annualized cost for the put.

 

So the cost of leverage (at 1.5% margin rate), winds up being 11.5% roughly for the margin+common+puts strategy with Interactive Brokers.

 

That includes full dividend protection of course.  So that's the most comparable to the warrant.

 

Still scratching my head -- at-the-money costs about 11.5% annually and 40%-out-of-the-money costs a bit more than 4% annually.

 

 

EDIT:  And at the rate that IB charges me, my annualized cost is less then 11%.  Roughly 10.75% is my cost.  So yes, rates may go up despite what Berknanke says, but keep in mind that it's 13% cost embedded in the warrants for the entire 6 years, and currenly 40% out-of-the-money BAC puts only cost 4% annualized including the current margin interest rates.  So that's a gap of something like 9% -- the distance between 4% and 13%.  Lot's of protection from rising interest rates embedded in that assumption.

 

[mankap]

Eric

How much leverage you can get with IB margin account.

If I put 100k , do you get leverage of 100k or more.

[ERICOPOLY]

Eric

How much leverage you can get with IB margin account.

If I put 100k , do you get leverage of 100k or more.

 

I believe if you have a "portfolio" margin account, hedging your common at $12 strike is the same as if you purchased $12 calls instead.

[Mephistopheles]

 

 

Here is one of the arguments, and perhaps the strongest:

 

1)  The most likely scenario being that the stock goes up over time.... 

2)  The puts in the LEAPS strategy can get rolled to higher strikes.

3)  Stock price crashes and your puts are at higher strike.

 

There it is.

 

Meanwhile, all along you had less money on the table.  Less at risk, safer strategy...  what's not to love?

 

Although, perhaps Mephistopheles had a separate argument comparing instrument to instrument?

 

Many people, if not everyone, on the board believed that the warrants are safer than the leaps because they have 4 additional years until expiration. Eric proved that a leaps strategy is in fact safer than owning the warrants. That's all I meant.

[ERICOPOLY]

 

 

Here is one of the arguments, and perhaps the strongest:

 

1)  The most likely scenario being that the stock goes up over time.... 

2)  The puts in the LEAPS strategy can get rolled to higher strikes.

3)  Stock price crashes and your puts are at higher strike.

 

There it is.

 

Meanwhile, all along you had less money on the table.  Less at risk, safer strategy...  what's not to love?

 

Although, perhaps Mephistopheles had a separate argument comparing instrument to instrument?

 

Many people, if not everyone, on the board believed that the warrants are safer than the leaps because they have 4 additional years until expiration. Eric proved that a leaps strategy is in fact safer than owning the warrants. That's all I meant.

 

And to think a half dozen people ridiculed the notion as "silly" or "ridiculous".  Hah  ;)

 

Maybe Sanjeev needs to create a "Taboo" section of the board where we can discuss the naughty topics.  Oh wait, don't the naughty peep shows always tend to attract the preachers?

[Sunrider]

 

 

Here is one of the arguments, and perhaps the strongest:

 

1)  The most likely scenario being that the stock goes up over time.... 

2)  The puts in the LEAPS strategy can get rolled to higher strikes.

3)  Stock price crashes and your puts are at higher strike.

 

There it is.

 

Meanwhile, all along you had less money on the table.  Less at risk, safer strategy...  what's not to love?

 

Although, perhaps Mephistopheles had a separate argument comparing instrument to instrument?

 

Many people, if not everyone, on the board believed that the warrants are safer than the leaps because they have 4 additional years until expiration. Eric proved that a leaps strategy is in fact safer than owning the warrants. That's all I meant.

 

And to think a half dozen people ridiculed the notion as "silly" or "ridiculous".  Hah  ;)

 

Maybe Sanjeev needs to create a "Taboo" section of the board where we can discuss the naughty topics.  Oh wait, don't the naughty peep shows always tend to attract the preachers?

 

Guys

 

In the interest of the debate culture on this board - you are now definitively gloating, which is neither nice nor appropriate and quite possibly premature.

 

Nothing has been proven by anyone (me included).

 

Eric argued and demonstrated that under a set of assumptions, in a specific scenario, using LEAPS is cheaper than the warrants. This does not equate to being the 'safer' investment - in a narrow or wider sense of that term.

 

Eric, you got annoyed with some other posters a while back who you felt were offensive. Your response has then led them to pretty much completely withdraw from this conversation, which I think is a loss for this board as this is not about any one of us winning an argument. At the end of the day, we're all responsible for our own investment decisions and so I'd rather have robust debate with everyone participating rather than one 'camp' intentionally or unintentionally drowning out the others.

 

What I think has sadly gone missing in this thread (and which was my original thrust of argument after having spent some time trying to understand yours) is reflection on the assumption and validity thereof on which you've built your argument. Some people here may well jump into this and get screwed by market movement and/or emotions because they won't hold enough cash in reserve to re-establish leverage/equivalent positions or don't dare because they'd be in shock if BAC goes down to and stays at 7 or so again.

 

Anyway - I very much hope your 'core' scenario comes to pass as I'll make a handy sum then as well but it feels to me that we've lost some of the diversity of views in this debate, which is a shame and I think that particular loss is easy enough for all of us to avoid.

 

Cheers - C.

[bennycx]

what if BAC expires below 12 at Jan 15 then the "cost of leverage" for leaps jump to 20%.. wouldn't that be more expensive than the warrants?

[ERICOPOLY]

what if BAC expires below 12 at Jan 15 then the "cost of leverage" for leaps jump to 20%.. wouldn't that be more expensive than the warrants?

 

This is why I mentioned the possibility of the stock being close to $12 at future rolls as the core weakness where potentially the warrants could come out ahead.

 

However, you said "below 12" just now.  The further it goes below $12, the better things looks for the LEAPS.

 

 

[ERICOPOLY]

Eric, you got annoyed with some other posters a while back who you felt were offensive. Your response has then led them to pretty much completely withdraw from this conversation, which I think is a loss for this board as this is not about any one of us winning an argument.

 

 

Ah yes, I miss the contributions which basically amounted to "this whole thread is ridiculous".  Comments like that make this board better for all.  Show up, insult everyone, drive on. 

[ERICOPOLY]

what if BAC expires below 12 at Jan 15 then the "cost of leverage" for leaps jump to 20%.. wouldn't that be more expensive than the warrants?

 

This is why I mentioned the possibility of the stock being close to $12 at future rolls as the core weakness where potentially the warrants could come out ahead.

 

However, you said "below 12" just now.  The further it goes below $12, the better things looks for the LEAPS.

 

 

Just to give you an example, if you were to roll the LEAPS later this year to at-the-money strike with the stock at $7 when the cost of leverage is at 20%, then you would be winning vs the guy holding the warrants. 

 

You are picking up $5 lower strike price in compensation for the higher premium paid -- it more than compensates you for the higher (now 20%) cost of leverage, so you gain.

[Straddle]

I have been holding 800 stocks of BAC due to a short put assignment. Average entry price around 7$-8$.  I was playing around a bit with the call options on BAC because I wanted more leverage.

After generating some pay-off graphs I realized I could almost duplicate my long stock position by replacing it with DITM Calls. I bought 9 LEAPS calls with strike 7$ and expiration date jan 2015.

I could almost take half the cash back in my account which was first locked up in the stock. 

 

Now I'm looking to add more average to my long position in BAC also with the 2015 calls. So far the best I like is the Bull Call spread 12-15 (long 12 call, short 15 call).

 

Anyone else who has been playing with the pay-off graphs of the LEAPS in BAC as well?

 

[Cardboard]

One disappointment that I have with this thread is that no one has even proposed a serious explanation as to why the BAC "A" warrants are so expensive vs the AIG ones or the BAC LEAPS. Makes no sense guys, long term options are always cheaper than ones of shorter duration. Sure, I have heard that the increase in dividend required for the BAC "A" warrants vs the AIG ones to adjust is less, but that seems short to explain the huge difference and also relative to the BAC LEAPS.

 

I have not had time to dig into the prospectus, but I will. Maybe that there is no reason and it is simply excessive demand for these warrants, but that seems truly odd considering their high amount of capital required to get in vs a LEAP or even the stock. I mean, if it was just "hope" for strike and conversion adjustments, then you would see volatility in what Ericopoly calls the cost of leverage. Sometimes the warrant would be at 7% cost of leverage when people would be pessimistic or like after the recent non-increase in the dividend and at other times at 13 or 15% when they would be more optimistic. No?

 

Cardboard

[zippy1]

One disappointment that I have with this thread is that no one has even proposed a serious explanation as to why the BAC "A" warrants are so expensive vs the AIG ones or the BAC LEAPS. Makes no sense guys, long term options are always cheaper than ones of shorter duration. Sure, I have heard that the increase in dividend required for the BAC "A" warrants vs the AIG ones to adjust is less, but that seems short to explain the huge difference and also relative to the BAC LEAPS.

 

I have not had time to dig into the prospectus, but I will. Maybe that there is no reason and it is simply excessive demand for these warrants, but that seems truly odd considering their high amount of capital required to get in vs a LEAP or even the stock. I mean, if it was just "hope" for strike and conversion adjustments, then you would see volatility in what Ericopoly calls the cost of leverage. Sometimes the warrant would be at 7% cost of leverage when people would be pessimistic or like after the recent non-increase in the dividend and at other times at 13 or 15% when they would be more optimistic. No?

 

Cardboard

Could it be that one can be cash settled and the other one can not be?

[Sunrider]

One disappointment that I have with this thread is that no one has even proposed a serious explanation as to why the BAC "A" warrants are so expensive vs the AIG ones or the BAC LEAPS. Makes no sense guys, long term options are always cheaper than ones of shorter duration. Sure, I have heard that the increase in dividend required for the BAC "A" warrants vs the AIG ones to adjust is less, but that seems short to explain the huge difference and also relative to the BAC LEAPS.

 

I have not had time to dig into the prospectus, but I will. Maybe that there is no reason and it is simply excessive demand for these warrants, but that seems truly odd considering their high amount of capital required to get in vs a LEAP or even the stock. I mean, if it was just "hope" for strike and conversion adjustments, then you would see volatility in what Ericopoly calls the cost of leverage. Sometimes the warrant would be at 7% cost of leverage when people would be pessimistic or like after the recent non-increase in the dividend and at other times at 13 or 15% when they would be more optimistic. No?

 

Cardboard

 

Hi Cardboard

 

The pessimism/optimism swings may be dampened greatly due to small float? I.e. with enough firm hands holding most of the warrants and the market makers knowing this the price would never move very far even if the marginal buyer/seller suffers from schizophrenia?

 

C.

[Cardboard]

MBIA is held by 3 large holders along with management and together it is over 60%. Look at the price swings!

 

Both BAC "A" warrants and AIG warrants trade a few million dollars worth each day. Seems relatively liquid to me for leveraged instruments. For comparison, the Jan 2015 BAC $12 call, traded 320 contracts on the CBOE yesterday or worth $68,800... You would think that the price discovery process out there would make the price converge at least between the BAC securities.

 

Zippy1, which one among these 3 can be cash settled? In any case, both BAC and AIG stocks are very liquid so this would not matter that much I would think.

 

Cardboard

[zippy1]

MBIA is held by 3 large holders along with management and together it is over 60%. Look at the price swings!

 

Both BAC "A" warrants and AIG warrants trade a few million dollars worth each day. Seems relatively liquid to me for leveraged instruments. For comparison, the Jan 2015 BAC $12 call, traded 320 contracts on the CBOE yesterday or worth $68,800... You would think that the price discovery process out there would make the price converge at least between the BAC securities.

 

Zippy1, which one among these 3 can be cash settled? In any case, both BAC and AIG stocks are very liquid so this would not matter that much I would think.

 

Cardboard

Oh, I was refering to the settlement at maturity.

 

I believe that BAC calls and BAC A warrants can be cash settled.  AIG warrants can not be settled with cash settlement at maturity.

 

However, since we are not at maturity date by a long time, I think this probably is not the reason, either. 

[ERICOPOLY]

There is yet another tax negative to the warrants that haven't yet been discussed.

 

Upon settlement, all shares delivered will have the same cost basis.  The warrant has dividend adjustments , but the way it's calculated is all shares will carry the same cost basis.

 

Your warrant may adjust to 1.5x shares, but all of them will carry the same cost basis.

 

Instead, a hedged common stock (with puts) approach will have dividends reinvested in new shares of stock.  Thus the more recently purchased shares are more likely to have a higher cost basis.  So when it's time to sell a few, you may be paying very little in capital gains tax.  Until you start selling the older-dated ones which are perhaps the more likely to be purchased at lower prices.

 

So if you assume BAC generally rises over time, and dividends get reinvested into more shares of stock, then under the puts+common+margin approach you have a tax advantage in being able to sell these higher cost basis shares and leaving the originally purchased lowest cost basis shares for last.

 

Now, you might get suspicious that the Treasury helped design the warrants given the tax problems with it  ::)

 

 

[redskin]

I may be looking at this the wrong way - but I am getting a 2-year option leverage cost that is a bit above the warrants. 

 

25 is the warrant-common break-even - ignoring the dividend readjustment but also ignoring dividends on the common - which is probably the right way to look at it (the readjustments should cancel each other out).  That implies an annualized cost of leverage of about 13%.

 

The two-year option at $2.10, ignoring dividends, gives you a 10% cost of leverage.  But the two-year options don't benefit from the dividend adjustment.  So the leverage cost of the options is 10% plus lost dividends over the next two years.

 

If you wanted to make an apples-apples comparison, one could use the post-adjustment strike and shares/warrant and compare that to the options.  Guessing at an $11 strike and 1.2 shares/warrant I get a break-even at $19 versus the common stock - implying a leverage cost of 8% plus lost dividends over the next 6 years (stock price at 12.06, warrant price at 5.54 as write).

 

Now of course we don't expect the bulk of the capital return in the next two years - so the 2015 options look ok in that regard.  But unless I am way off, the warrants look a little cheaper than the options.

 

EDIT: since you're paying for dividend protection up front, options could be cheaper over the next two years since serious dividends won't kick in until later.

 

Is this totally wrong?

 

 

Put it this way...

 

If $2.10 is the cost of the 2015 $12 strike call at a cost of leverage rate of 10% annualized, then at a 13% rate it would cost what... roughly 60 cents more (I'm not being exact, just winging it after 4 drinks in Death Valley and no calculator).

 

I have 60 cents of cash still in my pocket from paying a 10% rate instead of a 13% rate.

 

So I decide to invest that 60 cents in the stock at $12 per share.

 

Call it... a certain dividend that I get paid upfront.

 

Meanwhile, other people buying the warrants are implicitly speculating that the dividend over the next two years will exceed 60 cents.  So confident are they that they are paying the 60 cents upfront, hoping to get a dividend that exceeds 60 cents.  They'll lose money on that if it comes in below 60 cents (cumulatively over two years).

 

But it's better.  My way, I'm investing my 60 cents into the stock at $12 per share.

 

The warrant holder?  Maybe a some of the dividend gets invested at $12, maybe some at $15, maybe a good chunk of the 2nd year dividend gets invested at $18.

 

Hmm...  a 45 cent dividend invested at $18 is no better than a 30 cent dividend at $12.

 

Does anyone really want to throw away a certain 60 cents dividend reinvested at $12 today just to gamble on a bigger dividend that will probably get invested at a much higher price? 

 

So yes, the warrants ostensibly have "dividend protection" -- me, since I have the calls at 10% cost of leverage I have that approximate 60 cent dividend already invested in the stock at $12.

 

What do you calculate the cost of leverage being for the BAC B warrants?  Trading 0.72 with a strike price of 30.79.

[racemize]

What do you calculate the cost of leverage being for the BAC B warrants?  Trading 0.72 with a strike price of 30.79.

 

With the current dividends included, ~20%.  They have to go a long way to be in the money.  That being said, once they are in, the growth is explosive.