BAC leverage

[ERICOPOLY]

You advocated against owning the warrants because of the high COL, which you said was bound to come down, implying that the warrant will under perform the stock in that time.

 

I wasn't trying to imply that the warrant would underperform the stock, what I was trying to imply is that if you wanted non-recourse leverage the LEAPS+common were by far the better deal except under the very narrow scenario where the stock hovers right around $12 for the majority of the entire six years (in which case the leverage in the LEAPS+common scenario would continue to remain expensive for the lifetime of the warrants).

 

As merkhet pointed out, the warrants had much more time value.

 

I was cautioning people to not be in such a hurry to prepay for six years of the leverage when it is very expensive.  It should be intuitive to value investors not to go shopping at Costco to buy huge quantities of things  if their prices were higher than everyone else's and soon expected to fall steeply.  You might be willing to buy just one or two items at that price, but it's relatively crazy to want to buy a six pack when you strongly suspect the prices will soon drop by more than 50%.

 

 

[racemize]

Eric, I have a question re: the strategy from the beginning of this thread. I had dumped my warrants and bought options due to the cheaper cost of leverage, back when the stock was at $12 and the Jan '15 $12 strike calls were at $2.10. The cost of leverage for the option at the time was roughly 12%. Now, the stock is at $13.83 (up 15%), the option is at $3.11 (up 48%), and the COL has come down to 7%. I understand why this is so mathematically; but in simplistic terms, can you explain why the COL has come down so much while the option has gained so much more than the stock? You advocated against owning the warrants because of the high COL, which you said was bound to come down, implying that the warrant will under perform the stock in that time. Well then why has the option outperformed the stock (by a large margin) while the COL has come down so much? The COL for the warrant has come down too, but that one as you said has under performed the stock. So why doesn't this logic apply to the option?

 

Thanks in advance!

 

I think the thing to bear in mind here is that you still get the leverage of the option/warrant, so it should outperform the common if the common is growing greater than the paid COL.  More specifically, Eric wasn't saying that the warrants would underperform the common, but was instead comparing different vehicles that gives you comparable leverage.  For example, we know for a fact that the warrants would overperform the common if the common gets above 23.50 or so, so it isn't that they won't overperform generally, but that there is a headwind on the warrants that has to be overcome along the path to 23.5. 

 

Said another way, I've been thinking of the COL as a quasi-multiple of the option, e.g., as an analogy, the warrants are somewhat like owning a growth company where you know the P/E will contract going forward, but you expect the growth to overwhelm that contraction. 

 

Initially, the point was to avoid that known headwind and go to the LEAPs, which were cheaper.  What has happened is that both the LEAPs and the warrants have had a similar headwind (thought this depends a lot on when you bought the LEAPs), but the underlying leverage has allowed at least the LEAPs to grow over the top of the decrease in the COL.

 

Said another way, think of it like this:

common - no COL headwind, but no leverage

warrants - initial COL was around 13% with velocity of leverage (this is a term I've made up in order to compare leverages) at around 40%, current COL is 9.7%, resulting in underperformance versus the common

2015 12's - initial COL was 8% when Eric was first looking at it (although I guess you bought it at 12%) with velocity of leverage around 50-60%, current COL is ~7%

 

 

Also, what merkhet said re the length of the warrant/option.

 

Edit: and Eric just responded at the same time, so this may be useless.  I was trying to say the same thing in a different manner.

[Mephistopheles]

Thanks for the responses, guys. I played around with the numbers in my spreadsheet just to get a better understanding of everything. I get it more now, but I am not at the point where I can fluidly explain it lol. I'll give it a shot and you guys can tell me if I am on the right tracks.

 

Basically, when the option moved up 50% from $2 to $3, the equity portion of the investment only increased by $1, so the amount borrowed didn't decrease by much, and in fact it increased by $1 also since the stock moved up from $12 to $14. As a result, the COL decreased. It wouldn't have made sense for the option to move up much less than 50% because the COL, and the time value, would have come down to very small amounts, and that would have made the option a huge bargain.

 

The warrant, on the other hand, represents a large equity portion of the total investment, and the amount borrowed is relatively lower compared to the option. It wouldn't have made sense for the warrant to move up anywhere near the 50% rise seen in the option, because it would be adding a ton of time value, and as a result the COL would have gone even higher than it already was.

 

It made sense for the warrant to underperform the stock in order to allow the time value (which makes up a majority of its value) to come down a bit. Whereas 50% of the value of the option is intrinsic value, and in order to preserve some time value, the large increase in the premium price makes sense, given that there is still over a year and half remaining until expiration.

 

Feel free to tear this apart. :D Thanks again for helping this beginner!

[wescobrk]

This may be an incredibly basic question, but I'll ask anyway.

I own a few 15 strike 15 year BAC and they declined less than the 12 strike year 15 (4.5% compared to 5.1% roughly).

Shouldn't a lower strike option decline less than a higher strike with the same maturity?

Again, sorry if very basic question.

[wescobrk]

I meant to say compared to Friday's close the 15 strike declined less than the 12 strike.

Why is that?

[stahleyp]

I meant to say compared to Friday's close the 15 strike declined less than the 12 strike.

Why is that?

 

wesco, good question. The $15 strike is all time value for the pricing.  The $12 calls have intrinsic and time value.  When the stock drops, it impacts both on the $12s.

 

For instance, if the $12 strike is at $3 and the stock is at $13.50 - The intrinsic value of the option is $1.50. So, that's $1.5 for the $13.50 (current value) - $12 (strike). Plus $1.50 for time. Let's say tomorrow, the stock goes to $13, all of a sudden, your intrinsic value is cut to $1 and the time is still $1.5  (roughly since it's just one day less) for a total of $2.50

 

If the $15 strike is at $1.5 and the stock drops, the time value won't really change at all. Obviously, it is worth less now since the stock is further from the strike, but it's not affected as much since the strike is still a bit away. I hope that makes sense! :)

[ERICOPOLY]

I forget exactly when, but in 2007 or 2008 I owned WaMu calls for a day or two.  The stock suddenly dropped but even so (due to volatility spike) I sold for a gain.  Probably the most unexpected way to make money.  May be related to what wescobrk saw today with BAC.

[ERICOPOLY]

So now that the stock is above $14.19, the cost of a 2015 $12 strike BAC put has fallen to an "ask" of $1.00.

 

That's 18 months for $1.00.

 

Roughly 6% annualized.

[stahleyp]

Eric, how much do you have in BAC now that's unhedged? thanks in advance!

[ERICOPOLY]

Eric, how much do you have in BAC now that's unhedged? thanks in advance!

 

It's mostly hedged now. 

[racemize]

I am pretty shocked out how low these costs of leverages are getting--is there any good reason for it?  Perhaps this means that the options buyers think things are overvalued and/or a correction is coming?

 

e.g., look at WFC and JPM warrants. 2 and 3% cost of leverages.  BAC 10's are now 2%.

 

across the board, everything has come down a lot:

https://docs.google.com/spreadsheet/ccc?key=0AhTPR9eP5nWedEF1SGVLdllJTnBMSDMzM3lYZ2d0SlE&usp=sharing

[ERICOPOLY]

I am pretty shocked out how low these costs of leverages are getting--is there any good reason for it?  Perhaps this means that the options buyers think things are overvalued and/or a correction is coming?

 

My understanding is that cost of leverage (option premium) rises when people think a correction is coming.

[racemize]

I am pretty shocked out how low these costs of leverages are getting--is there any good reason for it?  Perhaps this means that the options buyers think things are overvalued and/or a correction is coming?

 

My understanding is that cost of leverage (option premium) rises when people think a correction is coming.

 

That seems like an odd reaction--if the market thought the prices would go down, then why would you pay more for upside leverage?

[Ross812]

The 2015 $10-$20 bull spread is now free leverage.

[ERICOPOLY]

I am pretty shocked out how low these costs of leverages are getting--is there any good reason for it?  Perhaps this means that the options buyers think things are overvalued and/or a correction is coming?

 

My understanding is that cost of leverage (option premium) rises when people think a correction is coming.

 

That seems like an odd reaction--if the market thought the prices would go down, then why would you pay more for upside leverage?

 

It's not called a "volatility" premium for nothing  :)

 

Put/call parity -- the volatility premium is the same for at-the-money option.  Whether it be put or call.  In practice the quote you see would differ slightly depending on expectations for dividends and interest rates (given that a call gets paid no dividend and you are synthetically borrowing money).

 

And on the bullish side, the fact that the stock went up $2.70 since we started this thread makes further upside volatility less likely (given that so much recovery is baked in).  Thus, less upside volatility premium as well.  I think when a stock is severely depressed and everybody knows it will rally big if X,Y,Z get cleared up, then it has a big volatility premium that will drop as the stock goes up (after X,Y,Z are cleared up).

[racemize]

And on the bullish side, the fact that the stock went up $2.70 since we started this thread makes further upside volatility less likely (given that so much recovery is baked in).  Thus, less upside volatility premium as well.  I think when a stock is severely depressed and everybody knows it will rally big if X,Y,Z get cleared up, then it has a big volatility premium that will drop as the stock goes up (after X,Y,Z are cleared up).

 

That explanation makes a lot of sense for something like BAC, but we've had compression on a lot of banks over the past six months (e.g., JPM is down from 5-6% to 2%), so I'm wondering if there is also a larger explanation overall?  Perhaps this is another Fed explanation (e.g., for the banks, everyone is happier than they were) or maybe just that the quality of earnings for all the banks increased...

[ERICOPOLY]

How about this...  you are a writer of put options.  You could instead just buy the stock.  So if the stock has huge upside, why would you write the put option without a big premium?

 

The cheaper the market (the more upside), it makes sense that put options should also be very expensive at the same time.  And when the market is peaking, it makes sense that at-the-money put options should be getting cheaper.

 

[racemize]

How about this...  you are a writer of put options.  You could instead just buy the stock.  So if the stock has huge upside, why would you write the put option without a big premium?

 

The cheaper the market (the more upside), it makes sense that put options should also be very expensive at the same time.  And when the market is peaking, it makes sense that at-the-money put options should be getting cheaper.

 

Right, that was my thought process above, but then we started talking about the opposite, where volatility pricing increased when a market correction was coming--that's where I got confused.

[ERICOPOLY]

How about this...  you are a writer of put options.  You could instead just buy the stock.  So if the stock has huge upside, why would you write the put option without a big premium?

 

The cheaper the market (the more upside), it makes sense that put options should also be very expensive at the same time.  And when the market is peaking, it makes sense that at-the-money put options should be getting cheaper.

 

Right, that was my thought process above, but then we started talking about the opposite, where volatility pricing increased when a market correction was coming--that's where I got confused.

 

I think people who sense a market crash coming due to some potential macro risk will start wanting to protect what they have or go short (and hedge he short with calls). 

 

But there must be a period in between, and perhaps that's where we are.

[portfoolio]

I just stumbled on this today and I'm enjoying this discussion very much. Right now I'm allocated 2/3 warrants and 1/3 medium-term options. I appreciate the arguments for rolling the warrants into LEAPs or just purchasing common outright.

 

I have some Warrants in my IRA. I purchased them for 3.99 on 11/2/2012. The common was trading at 9.85 then. So the stock is up about 50% since then and the warrant is up 60%. So, so far, the warrants haven't given much of a benefit, considering the extra risk of holding them vs. the common.

 

I have some more warrants I purchased 12/13/12 at $4.78. The common was trading 10.54 then. So that's even worse.

 

Of course, this may just mean that the warrants are undervalued right now and they will jump up after some event (lawsuit settlement?)

 

I think the common goes to $30 by the end of 2014 or middle of 2015. That would be 2x for the common and 3x for the warrants from here. I think dividends are going to be limited in that time frame, so I'm not too worried about that tax issue. It's an interesting question of whether it's worth the risk for that potential gain. Maybe it's not.

 

Of course, if the stock goes to $50 by 2019, you are looking at about 6x from here for the warrants vs. about 3.5x for the stock.

 

Anyway, raises lots of questions, and I appreciate the continued discussions.

[Sunrider]

portfoolio -

 

What do you mean with more risk in the warrants? Presumably you purchased them because you thought BAC would be above 13.3 + your purchase price at expiration (in quite a few year's time) ... and perhaps quite significantly so (judging by your comments on the main BAC WT-A thread). If you still believe that then why would they be more risky? Unless, of course, you equate risk with price volatility? If so then you actually made a counterpoint to yourself by noting that the warrants moved by less than the common ...

 

Anyway - not to be presumptuous but you may want to read up on option pricing/theory a little bit before you invest in these instruments. The fact that the warrants moved by less than the common is not unexpected for (a) there were not in the money for a big part of that price move, (b) there's lots of time less so there's less sensitive to the price movement of the underlying and © there's been a compression in implied volatility (what Eric calls the "cost of leverage") that has been working against the warrant price increasing.

 

If you still believe in your thesis then holding the warrants may not be such a bad idea. If you believe that BAC will definitely go to 25 by Jan 15/2015 then you should probably switch them for Jan 15 options for "cheaper leverage".

 

... just some thoughts ... C.

 

I just stumbled on this today and I'm enjoying this discussion very much. Right now I'm allocated 2/3 warrants and 1/3 medium-term options. I appreciate the arguments for rolling the warrants into LEAPs or just purchasing common outright.

 

I have some Warrants in my IRA. I purchased them for 3.99 on 11/2/2012. The common was trading at 9.85 then. So the stock is up about 50% since then and the warrant is up 60%. So, so far, the warrants haven't given much of a benefit, considering the extra risk of holding them vs. the common.

 

I have some more warrants I purchased 12/13/12 at $4.78. The common was trading 10.54 then. So that's even worse.

 

Of course, this may just mean that the warrants are undervalued right now and they will jump up after some event (lawsuit settlement?)

 

I think the common goes to $30 by the end of 2014 or middle of 2015. That would be 2x for the common and 3x for the warrants from here. I think dividends are going to be limited in that time frame, so I'm not too worried about that tax issue. It's an interesting question of whether it's worth the risk for that potential gain. Maybe it's not.

 

Of course, if the stock goes to $50 by 2019, you are looking at about 6x from here for the warrants vs. about 3.5x for the stock.

 

Anyway, raises lots of questions, and I appreciate the continued discussions.

[portfoolio]

portfoolio -

 

If you still believe in your thesis then holding the warrants may not be such a bad idea. If you believe that BAC will definitely go to 25 by Jan 15/2015 then you should probably switch them for Jan 15 options for "cheaper leverage".

 

I actually decided to do that very thing this week based on the discussion here.

 

I sold my Jan 2014 $15 calls and rolled them into two things: Jan 2014 $16 calls and Jan 2015 $17 calls. I then completely sold my warrants. I feel happier with this arrangement for lots of reasons. I just had too much riding on the Jan 2014 $15 calls.

[ERICOPOLY]

class A warrants selling for $6.29 today, up 12.3% since the discussion began.  Common stock is up 21.1% over same period.  Not quite double the performance of the warrants, but almost!

 

I believe cost of leverage is roughly 9.3% annualized at this point.  That's down from about 13.1% when this discussion began.

 

Somebody with 2x leverage would have made 42.2% over this period were there to be no decay in the cost of leverage (or time value loss).  So the erosion cost them about 30% -- a bit more than a 20% hit from the revaluation in cost of leverage over the remaining time period to expiry, and the rest from time decay.  Very costly leverage.

 

Maybe the stock is at $20 or $25 by 2015 -- that would probably cost another 20% (not including the time value decay -- if included, it's probably a 30% total cost of leverage for a period of only 1.25 years).  Makes the LEAPS continue to look relatively more attractive.

 

So we're only half-way there -- half the medicine has been swallowed.

 

 

[ERICOPOLY]

Actually, a $7 strike 2015 BAC put only costs 11 cents now at the ask.  The stock is about $7.50 above that strike price currently.  So about 1.27% annualized.  Cost of leverage then is a bit under 2% annualized if you have IB margin rates.

 

By this logic, when the stock hits $20.80 (about $7.50 above the warrant strike) the price of the warrant leverage could fall from today's 9.3% all the way down to 2%.

 

So lets say, hypothetically, the stock rallies to $20.80 by this January.  That would be 5 years before warrant expiry.  7.3% delta multiplied by 5 years would be 36.5% hit.

 

A move in the stock from today's $14.50 up to $20.80 would be a 43.44% move.  But if the warrants take a 36.5% cost-of-leverage revaluation hit, then the warrants give you barely any upside versus the common.  Probably only a 5% boost after you also include the time value decay between now and January -- about 2%.

 

So maybe you make 48.44% on the warrants instead of 43.44% in the common.  This might be the most severe case, but it's certainly possible based on how the $7 strike LEAPS puts are trading today.

[Redskin212]

Eric,

 

First off thanks for your posts on this subject - it has been very educational and profitable for me.

Back in March when this subject was talked about a lot I read every post over and over trying to figure out what you were trying to tell us.  I finally said wtf, the only way to really figure it out was to put a trade on.  The following is a summary of my actions:

 

Sold my 10,000 BAC A warrants at an average price of $5.81  - total proceeds $58,100 (March 20-25th 2013)

Purchased 100 Jan 2015 Calls, strike of $12 at average price of 2.40 - total cost $24,100 (march 25, 2013)

Purchased additional Calls to increase my exposure to BAC by 50%:

Purchased 25 Jan 2015 Calls, strike of $12 at average price of 2.33 - total cost $5,800 (march 26, 2013)

Purchased 25 Jan 2015 Calls, strike of $12 at average price of 2.02 - total cost $5,100 (April 5, 2013)

 

So I increase my exposure to BAC by 50%, however have approx. $23,000 less exposed

 

Today the A warrants closed at $6.30, so I would have made approx. $5,000 or 8.6% over the past 6 months if I had done nothing.

The Jan 2015 Calls closed today $3.20, so I am up about $13,000 or 37.5%!!

 

Needless to say I am a believer, I think this is the first time in my life that I have been "paid" to learn.

 

Thanks again