BAC leverage

[racemize]

I got a PM on this answer, and after toying with it for a while, here's some math to illustrate the point:

 

Let's take this to an extreme.  Let's assume you had a common share that you purchased for $10 versus the warrant having a strike of $10, and a special dividend is paid of $9.  Presumably the common would drop to $1, if the price was efficient, as it just lost 9$ of equity.

 

Common case:

nothing really changes here, as before it was 1 share at $10 and now it is 10 shares at $1 (since you used the $9 to buy 9 more $1 shares).  You still have $10 of stock.

 

warrant holder:

new strike = $10 * (10-9) / 10 = $1 (per share)

shares per warrant = 10/1 = 10

so, again, before we could get one $10 share, and now we can get 10 $1 shares

 

Note that the strike price is in "per share" units (at least according to my understanding).  So while, the shares per warrant is now 10, you will have to pay $10 (since it is $1 per share) and not $1 to get the 10 shares.  Saying it another way, the warrant gives you rights to purchasing the 10 shares, but at a price of $1 per share.  As a result, you are in the same situation before and after the dividend, with both the common and the warrant.  Thus, the adjustment to the warrant (both strike and shares) is simply the same as the math for the dividend and repurchase with the common.

 

I'm fairly sure this "per share" unit on the strike price is what is so confusing.  I struggled with this issue on the C warrants for a long time, because the 10:1 split affected both the strike price (increasing it by 10x) and the shares per warrant (decreasing by 10x).  If the units are not "per share" (which is also stated in the SEC filings, e.g., BAC A warrants states "at an exercise price of $13.30 per share"), then the adjustment makes absolutely no sense for them.  I think it would have been simpler to state them without the "per share" units, but here we are. 

 

If someone has interpreted these differently, then please correct me.  Or perhaps everyone already figured that out or knew it, and I was just being dense for a while.

 

RabbitisRich pointed out that the case I listed was artificial since the strike and common price were the same.  He pointed out that the adjustment maintains the leverage in the warrants.  To some extent, I did that on purpose to show the equivalency at 1:1, but it should also apply at other ratios, you just need to maintain the same amount of leverage (which is what Eric has been talking about in this thread).

 

E.g., consider the same situation as before, except the common price is $30 and a special dividend of $27 is declared (same 90%).

 

Common case (no leverage):

common price drops to $3, so you buy 9 more shares, giving you 10 shares at $3

 

common case (3:1 leverage, at $0 cost):

same as the no leverage case, you just only had $10 in, and margined the other $20.

 

warrant case (also 3:1 leverage, at $0 cost):

new strike = $10 * (30-27) / 30 = $1

shares per warrant = 10/1 = 10

 

So, before and after, you spend $10 to get $30 of shares (because of the warrants leverage), which is the same as the common case with 3:1 leverage.

[ERICOPOLY]

It shouldn't be too surprising that, with the warrants, the Treasury wanted to design a security that closely mirrored regular common stock ownership.

 

They tax the dividends just like they do with ordinary common stock.

 

And the warrants have some of the advantages of ordinary common stock -- you can take that dividend and reinvest it in the shares.  That's what the warrant adjustment accomplishes.

 

Why is at all that surprising that they offer no special Buried Gold of Cortez feature above and beyond that? 

 

The shackles they put on you suck, frankly:

1)  you are compelled to invest that dividend back into the stock, even if there are better stocks to choose from. 

2)  You are stuck with the same $13.30 strike on the put the entire time even though you'll want to raise the strike as the years go by

3)  The leverage hasn't even been cheap (which it should have been in order to compensate you for these negatives).

[Mephistopheles]

Eric, I was wondering what your thoughts are on when the best time to roll over the '15 options to the '16 ones, particularly for taxable accounts. I am considering waiting until January in order to push my taxes back for a year.

[ERICOPOLY]

Eric, I was wondering what your thoughts are on when the best time to roll over the '15 options to the '16 ones, particularly for taxable accounts. I am considering waiting until January in order to push my taxes back for a year.

 

This week I have been fly fishing in Oregon.  Not a lot of technology out here to stay connected with.

 

I noticed the $12 strike 2016 puts trading at only 58 cents premium to the 2015s.  That's only about 5% annualized cost for the put alone.  Not too bad. 

 

Best time to roll?  Well, if the stock drops back down near the strike price then rolling will likely be significantly more expensive (volatility might be up too).  If the stock goes up a buck or two over the next 3 months, the cost of rolling will go down.  It's the skew-ness thing -- the further away the stock is versus the strike price, then generally the cheaper it is to roll. 

 

Back in March the average cost for these warrants was 13% for the entire term.  Not only was the option cheaper out until 2015, but now the cost of rolling them out for another year is roughly 1/2 of what the warrants cost on average.  It will continue to be this way if the stock keeps heading north.

[Mephistopheles]

Eric, I was wondering what your thoughts are on when the best time to roll over the '15 options to the '16 ones, particularly for taxable accounts. I am considering waiting until January in order to push my taxes back for a year.

 

This week I have been fly fishing in Oregon.  Not a lot of technology out here to stay connected with.

 

I noticed the $12 strike 2016 puts trading at only 58 cents premium to the 2015s.  That's only about 5% annualized cost for the put alone.  Not too bad. 

 

Best time to roll?  Well, if the stock drops back down near the strike price then rolling will likely be significantly more expensive (volatility might be up too).  If the stock goes up a buck or two over the next 3 months, the cost of rolling will go down.  It's the skew-ness thing -- the further away the stock is versus the strike price, then generally the cheaper it is to roll. 

 

Back in March the average cost for these warrants was 13% for the entire term.  Not only was the option cheaper out until 2015, but now the cost of rolling them out for another year is roughly 1/2 of what the warrants cost on average.  It will continue to be this way if the stock keeps heading north.

 

Thanks for the response. I think you are referring to rolling the same strike price to another year out, right? So you mean rolling $12 '15 calls to $12 '16? What if I was rolling $12 '15 calls to say, $15 '16 calls? The reason I was thinking of this was to increase the strike of the implied put, a strategy I think you referred to earlier in the thread. Didn't you say it was better to roll into whatever the ATM option is for this reason?

 

Maybe I should just buy the stock and puts since they are cheap. I am hesitant though because it will eat up a lot of my capital...

[ERICOPOLY]

Eric, I was wondering what your thoughts are on when the best time to roll over the '15 options to the '16 ones, particularly for taxable accounts. I am considering waiting until January in order to push my taxes back for a year.

 

This week I have been fly fishing in Oregon.  Not a lot of technology out here to stay connected with.

 

I noticed the $12 strike 2016 puts trading at only 58 cents premium to the 2015s.  That's only about 5% annualized cost for the put alone.  Not too bad. 

 

Best time to roll?  Well, if the stock drops back down near the strike price then rolling will likely be significantly more expensive (volatility might be up too).  If the stock goes up a buck or two over the next 3 months, the cost of rolling will go down.  It's the skew-ness thing -- the further away the stock is versus the strike price, then generally the cheaper it is to roll. 

 

Back in March the average cost for these warrants was 13% for the entire term.  Not only was the option cheaper out until 2015, but now the cost of rolling them out for another year is roughly 1/2 of what the warrants cost on average.  It will continue to be this way if the stock keeps heading north.

 

Thanks for the response. I think you are referring to rolling the same strike price to another year out, right? So you mean rolling $12 '15 calls to $12 '16? What if I was rolling $12 '15 calls to say, $15 '16 calls? The reason I was thinking of this was to increase the strike of the implied put, a strategy I think you referred to earlier in the thread. Didn't you say it was better to roll into whatever the ATM option is for this reason?

 

Maybe I should just buy the stock and puts since they are cheap. I am hesitant though because it will eat up a lot of my capital...

 

Not necessarily better to always be at-the-money when rolling.  But certainly safer.  And the $15 strike puts are now cheaper (annualized) than what people paid (annually) for embedded puts with $13.30 strike (the warrants).  For the amount of money people were paying, they could instead be getting at-the-money strike adjustments when they roll the LEAPS.

 

I don't want to roll my 2015s yet for a variety of reasons.

1)  tax  -- I'm presently in a blackout period due to wash sale rule

2)  If I roll to the $15 strike I want the stock to be above $15 at the time (I believe otherwise I risk triggering a "constructive sale").

3)  I feel like the stock will be a couple of dollars higher in the spring -- I'd like to roll then to save money on the roll

[LC]

How is it that the cost to roll is cheaper when the stock is above the strike? Eric, you mention "skewness". Can you elaborate on that?

 

 

[ERICOPOLY]

How is it that the cost to roll is cheaper when the stock is above the strike? Eric, you mention "skewness". Can you elaborate on that?

 

Of course, it could also be cheaper if the stock moved down below strike (not just up above it) -- basically, the further away from strike price, the cheaper to roll (whether that be significantly above or below strike)

 

Look for example at the prices expressed as a percentage of strike.  The closer the strike is to the current stock price, the more expensive the put is (expressed as a percentage of strike price).

 

2016 puts:

$8 strike for 33 cents  (4.125%)

$10 strike for 67 cents  (6.7%)

$12 strike for 124 cents  (10.33%)

 

Right, so let's say the stock rises by $4 from present levels.  Maybe the $12 strike will fall to just 4% of strike (similar to how the $8's are priced today).  So there is more art to this than simply time decay and volatility -- if you think the stock price will pop around March, it might pay off to delay your rolling until then.

 

 

[meiroy]

 

 

Any idea why the warrants on IB have maint. margin of 100% on t-reg?

 

BTW I think it's good to have a reminder that non US tax payers will not have to pay taxes on the dividends adjustments while they would be taxed on the dividends from the common.

[gary17]

Hi Eric, thanks for your reply , i think i found the BAC Leverage thread

Some more questions:

-do option prices reflect whether the market is optimistic or pessimistic about a particular security or they simply reflect the volatility?

 

-do people hold LEAPS so they can sell the option prior to maturity if the share price has reached the IV?  let's say for example I think BAC is worth $25, i'm not sure when it'll be $25 but i feel there's a good chance it will be there before Jan 16.  I buy the $10 call for $5.00      So if let say some time next year it reached $25, theoretically the premium should be worth a bit less than $25 - 10 = $15?  So the call option is now worth 3 times? ($15 / $5 = 3)? 

 

OR

- do people hold it until maturity and buy the stock at $10 (total cost of $15) and make the difference of $25 - $15 = $10 ?

 

may be this question has been asked already.... forgive me if I'm a bit lazy to loook it up :P 

 

thanks !

 

 

 

 

hi Eric

I've been reading up on BAC for the last few months and finally decided to take a position (commons) when it dropped a bit during the shut down. 

 

I'm wondering if you could shed some light on buying LEAPS -  let say the commons are at 14  and i'm looking at 2016 january calls with 8, 10 and 12 dollar strikes.

 

The premiums are 6.50, 4.85, and 3.55 , respectively.

 

I kinda look at the premiums as buying shares at a 'discount' although they are really part of the options.

 

I haven't done options much - so if BAC is at 20, what would the premiums be at?  Is it not more or less the difference between 20 and the strike price.  This would suggest the lower the strike price the less volatility of the premiums. 

 

I'm wondering if this is the right way of looking at call options.

 

Thanks

 

I started the 'BAC Leverage' thread when people complained that the BAC warrants thread wasn't for discussing leverage.  Oh, okay, maybe I'm not being that funny.  But if I start talking about warrants again here on the warrants thread I'm sure I'll get more complaints.

 

Read that thread and it should answer the questions.  There is a lot of discussion about how there are two components to pricing in the option -- one is the difference between $20 and strike (in your example), and the other is the one that is affected by many things, including how far the current stock price is from the strike price. 

 

Anyways, I think you can get a lot of insight just from staring at this table:

http://finance.yahoo.com/q/op?s=BAC&m=2016-01

 

You can see for example how a put option is a higher percentage of the stock price when the stock is nearer the strike price, but puts struck at prices that are further away from the current stock price get cheaper (expressed as a percentage of their respective strike prices).  So in short, to answer your question the calls will be priced the same way as the stock rises to $20.  Every call effectively is logically the same as having the benefit of owning a leveraged common share (without a dividend) and with a put embedded within it (so the leverage is non-recourse).  Well, it's the synthetic equivalent of that logic.  Anyways, if you have another question bring it up on the BAC leverage thread or somebody is going to complain again about discussing leverage on a thread about warrants  :D

[LC]

I don't think very many people trading options actually exercise them...perhaps the exception being when selling puts to enter a position.

[Mephistopheles]

 

-do people hold LEAPS so they can sell the option prior to maturity if the share price has reached the IV?  let's say for example I think BAC is worth $25, i'm not sure when it'll be $25 but i feel there's a good chance it will be there before Jan 16.  I buy the $10 call for $5.00      So if let say some time next year it reached $25, theoretically the premium should be worth a bit less than $25 - 10 = $15?  So the call option is now worth 3 times? ($15 / $5 = 3)? 

 

 

It should be worth more than $15, not less, because it will have time value as well.

[ERICOPOLY]

BAC common:  $14.15

A warrant:  $6

 

14.15 - 6 = 8.15

 

8.15 * 1.1 * 1.1 * 1.1 * 1.1 * 1.1 = 13.12  (strike is 13.30)

 

So the leverage in the warrant is back to roughly 10% annualized cost of leverage it looks like.

 

I was wondering what would happen if the common were to appreciate by 15% over the next year.  It seems like the warrant would gain 20% if the cost of leverage is still 10% a year from now.  However if the cost of leverage slips to 8%, then the warrant would only gain 12% (less than the common).

 

I doubt the cost of leverage will remain at 10% if the stock rises to $16.  That $13.30 put becomes more and more meaningless when it offers little protection from a fall -- and the higher the stock is above strike, the larger the fall (and thus the less value of the $13.30 put).  That's basically the argument for skewness -- a put at $12 protects you from a 40% fall when the stock is at strike, but when the stock is at $20, it does nothing to protect from 40% fall.  So that's why the cost of leverage declines as the stock rises (if anyone was still wondering  :))

[LC]

Damn Eric, I owe you a beer. That question has been on my mind for the few weeks since it came up in this thread. Very well explained, thank you!

[stahleyp]

eric, you may have answered this before and apologize if I missed it, but when would the warrants look more attractive to you?

[ERICOPOLY]

eric, you may have answered this before and apologize if I missed it, but when would the warrants look more attractive to you?

 

Let me answer by saying that I wouldn't have this bias against the warrants if I believed the stock to be fully valued. 

 

You see, I believe the earnings will improve over the next 18 months.  For that reason, I believe the stock will rise materially.  Therefore, I believe I will be able to roll my puts at much cheaper cost of leverage.

 

I don't believe paying 10% per year to be absurd if the stock is going to remain at $14 for all 5 years.  But that's just the thing, I don't believe that.  Rather, I believe it will appreciate by an outsized amount.

 

It doesn't mean that Black Scholes is wrong, because it's just using the current stock as input.  But if the current stock price is wrong, then you know the saying... "garbage in, garbage out". 

 

[stahleyp]

Ahh, I think I get it. If you expect an outsized bump over the next year or two, why pay extra for the warrant's time if a good part of the upside should happen much sooner. Thanks man! :)

[ERICOPOLY]

Since this thread began in March, when the common was at $12 and "A" warrants were at $5.60:

 

"A" warrants are up 2.5%  (closed today at $5.74)

Common is up 16%      (closed today at $13.93)

 

That's brutal. 

 

 

[gary17]

eric, you may have answered this before and apologize if I missed it, but when would the warrants look more attractive to you?

 

Let me answer by saying that I wouldn't have this bias against the warrants if I believed the stock to be fully valued. 

 

You see, I believe the earnings will improve over the next 18 months.  For that reason, I believe the stock will rise materially.  Therefore, I believe I will be able to roll my puts at much cheaper cost of leverage.

 

I don't believe paying 10% per year to be absurd if the stock is going to remain at $14 for all 5 years.  But that's just the thing, I don't believe that.  Rather, I believe it will appreciate by an outsized amount.

 

It doesn't mean that Black Scholes is wrong, because it's just using the current stock as input.  But if the current stock price is wrong, then you know the saying... "garbage in, garbage out".

 

Eric , do you mind explaining what you mean by "roll my puts".  Do you mean you are buying puts or selling puts?  Thanks

 

[ERICOPOLY]

eric, you may have answered this before and apologize if I missed it, but when would the warrants look more attractive to you?

 

Let me answer by saying that I wouldn't have this bias against the warrants if I believed the stock to be fully valued. 

 

You see, I believe the earnings will improve over the next 18 months.  For that reason, I believe the stock will rise materially.  Therefore, I believe I will be able to roll my puts at much cheaper cost of leverage.

 

I don't believe paying 10% per year to be absurd if the stock is going to remain at $14 for all 5 years.  But that's just the thing, I don't believe that.  Rather, I believe it will appreciate by an outsized amount.

 

It doesn't mean that Black Scholes is wrong, because it's just using the current stock as input.  But if the current stock price is wrong, then you know the saying... "garbage in, garbage out".

 

Eric , do you mind explaining what you mean by "roll my puts".  Do you mean you are buying puts or selling puts?  Thanks

 

I mean, for example, selling my 2015s and replacing them with 2016s.  I am "rolling them" to a later expiration date, rather than letting them expire.

 

Today, my $12 strike puts are 2015 expiration.  It would cost me an incremental 65 cents to roll them from 2015 to 2016.  I sell the 2015s for 70 cents "bid" and replace them with 2016s for $1.35 "ask".  So that's an incremental 65 cents, which is currently the bid/ask cost of rolling them out by 12 months.

 

 

[gary17]

So you are buying / selling puts -  can you please let me know how that compares with selling / buying calls?  (sorry if this is a dumb question - I don't do options, but I really want to understand exactly why investors do certain things)

Thanks

[ERICOPOLY]

So you are buying / selling puts -  can you please let me know how that compares with selling / buying calls?  (sorry if this is a dumb question - I don't do options, but I really want to understand exactly why investors do certain things)

Thanks

 

I have a leveraged position.  But this is margin debt, so to make it non-recourse I buy puts.  Long a share of common, using debt, but also long a put.  Thus, the most I stand to lose is the cost of financing... because the loan itself is non-recourse.

 

It's like buying a home where you put zero money down, and walk away if the price goes down.  Except I'm doing it with common stocks instead of real estate, and I'm partically prepaying the cost of the non-recourse financing (the cost of the put).

[ERICOPOLY]

And if I successfully select undervalued stocks that soar and stay that way, the cost of the non-recourse financing will be extremely cheap... this is because once the stock has appreciated substantially the cost of rolling the puts goes down.  It's only expensive for the initial time period until the stock soars.  Then it gets really cheap afterwards.

 

And the whole time it's non-recourse.  I mean, these puts cost less money than BAC is generating on a per-share basis.  So with patience, the strategy will pay off.

[Uccmal]

Eric, If I may.  I have about 80% of my BAC Leaps hedged via puts at an assortment of expiry dates and strikes.  Anyway, that isn't my question. 

 

You say you are doing this in a margin account.  The question is this: Does your broker match the puts and calls, or are you just working it out that way on a one to one basis?

 

None of my options are actually marginable with TD.  They just eat up alot of cash.

 

I agree, with BAC in particular, the cost of the puts is easily covered when the stock prices rise rapidly.  The worst case scenario is if BAC stays for 2 yrs. at around this price.  Now, even that scenario has a couple of assumptions:

1) I don't do anything such as rolling things further out in the interim, which for me is unlikely.

2) That BACs price stays at $14 continuously for two years - the probability of that is likely closing on zero. 

[gary17]

And if I successfully select undervalued stocks that soar and stay that way, the cost of the non-recourse financing will be extremely cheap... this is because once the stock has appreciated substantially the cost of rolling the puts goes down.  It's only expensive for the initial time period until the stock soars.  Then it gets really cheap afterwards.

 

And the whole time it's non-recourse.  I mean, these puts cost less money than BAC is generating on a per-share basis.  So with patience, the strategy will pay off.

 

Eric, thanks - just curious though, and apologies if you already explained this in this long thread - how does this compare to simply buying Jan 2016 calls? 

 

Let's say I have $10,000 and want to borrow $4,000 to buy 1000 shares of BAC at $14/share today. 

And I buy the $12 strike put for $1.32 - so my total cost is $14 + $1.32 = $15.32 /share

Let's assume upside of $20 so my upside is $5ish / share or 50% based on the initial $10,000 investment less some interests on the borrowed money.

Let's assume downside is it goes below $12 and I end up losing $3.32/share or $3320 which is like a 33% loss. 

 

So how is this different from buying $12 strike call for $3.55 today -  for 1,000 shares my cost is only $3550.  No interest since i'm not borrowing money. 

If it's $20 then my upside is quite significant - the call is probably worth $20 - $12 = $8 , divided by $3.55 is a bit more than 200% gain

If it's anything lower than $12, i'd just lose $3550 which is almost the same as $3320 noted above. Yes, it's a 100% loss, but the absolute loss figure is about the same. 

 

The one advantage I could see with long commons while buying put is you still get to keep the shares - that is, if the upside doesn't materialize and one feels there's still a very good chance it'll work, then you could sell the put option and keep the commons whereas the call in the 2nd example would be completely gone... 

 

Thanks