BAC leverage

[ERICOPOLY]

Hi Eric

When you bought the $12 puts - how much was the share price of BAC and the premium of the puts.  I just want to get an idea of how much cheaper it got during this time as the BAC commons appreciated....   

 

thanks

Gary

 

The stock was at $12 in March 2013 when I paid around $1.20 for $12 strike Jan 2014 puts.

 

They expire two weeks from today. 

 

Today, they can be rolled to the 2015 $12 strike puts for just 36 cents. 

 

So the puts cost $1.20 for the first 10 months, and now they are just 36 cents for an additional 12 months.

 

It has been a non-recourse loan where the adjustable rate went down dramatically.  The price should be even cheaper this time next year if the stock continues to climb.

[argonaut]

Hi Eric,

 

This discussion is quite interesting and I appreciate your sharing your knowledge..my comment is if BAC had just say muddled along instead of heading up in 2013 then the option for another 9 months out might cost around the same and at that point you have spent say 20% total above the purchase prides in puts ... your break even is now 20% higher and thus this only works for volatile and or rising stocks?

[ERICOPOLY]

Hi Eric,

 

This discussion is quite interesting and I appreciate your sharing your knowledge..my comment is if BAC had just say muddled along instead of heading up in 2013 then the option for another 9 months out might cost around the same and at that point you have spent say 20% total above the purchase prides in puts ... your break even is now 20% higher and thus this only works for volatile and or rising stocks?

 

Yes, absolutely. 

 

Leverage only works for rising stocks, unless your cost of leverage is zero.

[bmichaud]

^

 

Precisely why your advice should come with the "do not try at home" disclaimer. The genius in your approach is not leverage and/or your ability to craft intricate option strategies, but rather the ability to find stocks that rise and rise a lot in a short amount of time :)

[ERICOPOLY]

Aside from just leverage...

 

The approach lets me put all of my unleveraged capital into the one idea.

 

Worst case, in the first year I lose only the cost of the put.

 

Some of you guys are holding 40% cash.  The 60% you have invested in equities can be down by at least 50%, and then you've got a total decline of 30%, versus my 10% worst case.

 

And the opportunity cost of holding 40% cash can be 20% hit to your performance if you could have otherwise earned 50% on it.

 

 

Look at Pabrais approach of requiring a 5x return on that last 10% of cash.  Well, suppose I merely require a 2x return on that last 10% of my cash, and I chase that opportunity while buying an at-the-money put that costs me 10%.  Okay, so I won't be that far behind him (only 10% cost) if the market then presents 5x opportunities over the course of the next 12 months, and on all the years when it doesn't I will be gaining ground if I'm earning returns in excess of the cost of that put.  Plus, I find it easier to not hold cash.

 

 

[TwoCitiesCapital]

Eric,

 

Forgive me if you've beaten this topic to death. I like your way of evaluating the cost of leverage and I want to make sure I understand it and fully before adopting as the way I do it in the future.

 

Let's take a real world example.

 

Jan '16 calls for SHLD are at a mid-market of $12 at a $45 strike. Let's assume for simplicity that the stock is at $45. Using your cost of leverage would suggest that leverage was about 18% per annum (not compounded) [12/(45-12)/2]. The $12 strike is the interest paid upfront, the $33 in the numerator is essentially the premium borrowed, and the 2 is for the fact that it gives you 2 years of exposure. This mostly makes sense to me.

 

I have a few questions:

1) How do you adjust your cost of leverage expense rate for the fact that interest is paid up front instead of amortizing the expense over time? 18% up front is more expensive then 18% broken out over time. The higher the rate, the bigger the difference in the two rates' effect on returns.

 

2) How do you adjust your approach when the strike price isn't the same as the stock price? Certainly there needs to be an adjustment to include the appreciation that the stock would have to earn before breaking even. It seems like this could be solved by simply backward solving for the rate of return needed. Example below:

 

Sears is currently at $44. If I buy the $12 jan 16 $45.000 calls, I would need the stock to return $13 over the next two years to break even. Wouldn't the cost of leverage be this $13 divided by the principal I'm borrowing (44-12) bumping up the annual rate from 18% to 20%?

 

3) At the beginning of the thread you said you liked BofA options over WFC even though WFC had cheaper leverage. Your reasoning was that that WFC had cheaper leverage because the market didn't expect WFC to make big moves. This seems counter-intuitive though. The idea is to buy options when they appear to be cheaper than the they should be (due to temporarily low volatility or a misunderstood future catalyst) resulting in a lower cost of leverage. What you were saying is that you preferred BofA's precisely because it's leverage was more expensive (the market baked in a possibility of a large price appreciation). I don't understand that as a justification if the market had already priced it in. Can you enlighten me?

[ERICOPOLY]

Eric,

 

Forgive me if you've beaten this topic to death. I like your way of evaluating the cost of leverage and I want to make sure I understand it and fully before adopting as the way I do it in the future.

 

Let's take a real world example.

 

Jan '16 calls for SHLD are at a mid-market of $12 at a $45 strike. Let's assume for simplicity that the stock is at $45. Using your cost of leverage would suggest that leverage was about 18% per annum (not compounded) [12/(45-12)/2]. The $12 strike is the interest paid upfront, the $33 in the numerator is essentially the premium borrowed, and the 2 is for the fact that it gives you 2 years of exposure. This mostly makes sense to me.

 

I have a few questions:

1) How do you adjust your cost of leverage expense rate for the fact that interest is paid up front instead of amortizing the expense over time? 18% up front is more expensive then 18% broken out over time. The higher the rate, the bigger the difference in the two rates' effect on returns.

 

2) How do you adjust your approach when the strike price isn't the same as the stock price? Certainly there needs to be an adjustment to include the appreciation that the stock would have to earn before breaking even. It seems like this could be solved by simply backward solving for the rate of return needed. Example below:

 

 

Sears is currently at $44. If I buy the $12 jan 16 $45.000 calls, I would need the stock to return $13 over the next two years to break even. Wouldn't the cost of leverage be this $13 divided by the principal I'm borrowing (44-12) bumping up the annual rate from 18% to 20%?

 

 

 

Take the stock price of $44.  Subtract off $12 for the price of the call.  That leaves you with $32.  The compound rate at which $32 grows to $45 will be the cost of leverage.  Let me explain:  it won't be until you exceed $45 that you have any gain at all -- therefore, the rate at which $32 grows to $45 will be the cost of leverage.

 

That answers both questions above.  It not only accounts for the fact that the interest was paid upfront, but it also accounts for the fact that the strike price ($45) is higher than the current market price.

 

[gary17]

I look at this slightly different but same answer.

 

The premium is $12 and strike is $45 so this purchase means you are committed to pay $57 per share if the share hits the strike .... but you are just paying $12 today.... this freed you up from having to pay the balance.... hence a slight premium.

 

The premium is $57 less $44 or $13... the cost of leverage.

 

The true cost will likely be less than $13... if the investment plays out and you sold at some point before expiration... but I haven't had that happen to me yet. maybe Eric could comment. Thanks

[ERICOPOLY]

3) At the beginning of the thread you said you liked BofA options over WFC even though WFC had cheaper leverage. Your reasoning was that that WFC had cheaper leverage because the market didn't expect WFC to make big moves.

 

My reasoning was that BAC options were relatively more expensive due to the stock being depressed by "uncertainty".  Lifting of uncertainty would lead to upwards price volatility, hence the larger volatility premium.

 

 

This seems counter-intuitive though. The idea is to buy options when they appear to be cheaper than the they should be (due to temporarily low volatility or a misunderstood future catalyst) resulting in a lower cost of leverage.

 

I never buy options because they are "cheaper than they should be".  That's something I definitely never do.  I only buy them for non-recourse leverage on a rising stock price.  There is no other reason for me buying them.

 

 

What you were saying is that you preferred BofA's precisely because it's leverage was more expensive (the market baked in a possibility of a large price appreciation). I don't understand that as a justification if the market had already priced it in. Can you enlighten me?

 

I preferred BofA because I thought the stock would go up faster.  I certainly didn't choose it because the leverage was more expensive. 

 

What did the market already price in?  The stock was at $12 10 months ago and now it's at $16.60.  That's $4.60 a share appreciation and it only cost $1.20 for the at-the-money put that is expiring next week.  The successive put (the $12 strike 2015) now only costs 31 cents.  So now only 2.65% per year going forward (and it will drop further for future years as the stock rises).

 

[gary17]

hi Eric, I'm wondering if I could get your thoughts on if jan 2016 puts are better for 2015 puts

 

I mean, from your experience, is it cheaper to buy them on an annual basis or just buy the longer duration at once.  The 2016 seems to have gotten cheaper ... At 1.8 that's 90c a year whereas the jam 15 is $1. But I suppose if BAC starts to rise then 2016 puts should get quite cheap by end of this year... But does it go down linearly. Thanks

[ERICOPOLY]

hi Eric, I'm wondering if I could get your thoughts on if jan 2016 puts are better for 2015 puts

 

I mean, from your experience, is it cheaper to buy them on an annual basis or just buy the longer duration at once.  The 2016 seems to have gotten cheaper ... At 1.8 that's 90c a year whereas the jam 15 is $1. But I suppose if BAC starts to rise then 2016 puts should get quite cheap by end of this year... But does it go down linearly. Thanks

 

It's not clear to me which one is better.  There are scenarios where one way is better than the other, and vice versa.  I had a greater bias to one scenario over the other ten months ago when the stock was at $12.

 

It does seem clear to me though that as the company accrues earnings, settles liabilities, runs off bad loans, grows earnings, etc... etc.. etc...  The $15 put is more likely to be in the money over the shorter term than over the very long term.  You'll get another $2 of cash earnings throughout 2015 -- likely only a minority portion of that will be returned via dividends throughout the 2015 year.

 

So one thought I've been entertaining is that perhaps a $15 strike put for 2015 is the rough risk-adjusted equivalent of a $14 strike put for 2016, and perhaps a $13 strike put for 2017.

 

Unfortunately though, they are not offering a $14 strike put for 2016.  Not yet anyway.

 

This isn't advice, but have you looked into writing covered calls as a way to reduce your time premium risk?  The only one I see incredibly unlikely to be breached is the $30 strike call.  It traded for 30 cents today.  Of course, if you are thinking of selling the stock after a quick pop that would prove to be a mistake (you'd be likely buying it back for a loss), but if you intend to hold the position until maturity for tax reasons (like me), then perhaps it's not so stupid -- after all, it reduces the net risk I've exposed myself to from option premium decay.  I could take that money and buy back some of the puts that I've written on other names, for example.

 

[gary17]

hi Eric, I'm wondering if I could get your thoughts on if jan 2016 puts are better for 2015 puts

 

I mean, from your experience, is it cheaper to buy them on an annual basis or just buy the longer duration at once.  The 2016 seems to have gotten cheaper ... At 1.8 that's 90c a year whereas the jam 15 is $1. But I suppose if BAC starts to rise then 2016 puts should get quite cheap by end of this year... But does it go down linearly. Thanks

 

It's not clear to me which one is better.  There are scenarios where one way is better than the other, and vice versa.  I had a greater bias to one scenario over the other ten months ago when the stock was at $12.

 

It does seem clear to me though that as the company accrues earnings, settles liabilities, runs off bad loans, grows earnings, etc... etc.. etc...  The $15 put is more likely to be in the money over the shorter term than over the very long term.  You'll get another $2 of cash earnings throughout 2015 -- likely only a minority portion of that will be returned via dividends throughout the 2015 year.

 

So one thought I've been entertaining is that perhaps a $15 strike put for 2015 is the rough risk-adjusted equivalent of a $14 strike put for 2016, and perhaps a $13 strike put for 2017.

 

Unfortunately though, they are not offering a $14 strike put for 2016.  Not yet anyway.

 

This isn't advice, but have you looked into writing covered calls as a way to reduce your time premium risk?  The only one I see incredibly unlikely to be breached is the $30 strike call.  It traded for 30 cents today.  Of course, if you are thinking of selling the stock after a quick pop that would prove to be a mistake (you'd be likely buying it back for a loss), but if you intend to hold the position until maturity for tax reasons (like me), then perhaps it's not so stupid -- after all, it reduces the net risk I've exposed myself to from option premium decay.  I could take that money and buy back some of the puts that I've written on other names, for example.

 

Thanks. Yes , I have been looking at covered calls as a way of generating some income while I wait. But the 30c you noted I believe is in 2016... Why not sell them on a short term basis every two months ?  (Not asking for advise. Just want to see how you think about selling covered calls.)

Thanks.

[ERICOPOLY]

hi Eric, I'm wondering if I could get your thoughts on if jan 2016 puts are better for 2015 puts

 

I mean, from your experience, is it cheaper to buy them on an annual basis or just buy the longer duration at once.  The 2016 seems to have gotten cheaper ... At 1.8 that's 90c a year whereas the jam 15 is $1. But I suppose if BAC starts to rise then 2016 puts should get quite cheap by end of this year... But does it go down linearly. Thanks

 

It's not clear to me which one is better.  There are scenarios where one way is better than the other, and vice versa.  I had a greater bias to one scenario over the other ten months ago when the stock was at $12.

 

It does seem clear to me though that as the company accrues earnings, settles liabilities, runs off bad loans, grows earnings, etc... etc.. etc...  The $15 put is more likely to be in the money over the shorter term than over the very long term.  You'll get another $2 of cash earnings throughout 2015 -- likely only a minority portion of that will be returned via dividends throughout the 2015 year.

 

So one thought I've been entertaining is that perhaps a $15 strike put for 2015 is the rough risk-adjusted equivalent of a $14 strike put for 2016, and perhaps a $13 strike put for 2017.

 

Unfortunately though, they are not offering a $14 strike put for 2016.  Not yet anyway.

 

This isn't advice, but have you looked into writing covered calls as a way to reduce your time premium risk?  The only one I see incredibly unlikely to be breached is the $30 strike call.  It traded for 30 cents today.  Of course, if you are thinking of selling the stock after a quick pop that would prove to be a mistake (you'd be likely buying it back for a loss), but if you intend to hold the position until maturity for tax reasons (like me), then perhaps it's not so stupid -- after all, it reduces the net risk I've exposed myself to from option premium decay.  I could take that money and buy back some of the puts that I've written on other names, for example.

 

Thanks. Yes , I have been looking at covered calls as a way of generating some income while I wait. But the 30c you noted I believe is in 2016... Why not sell them on a short term basis every two months ?  (Not asking for advise. Just want to see how you think about selling covered calls.)

Thanks.

 

The shorter term calls (like the August $22 strike) tend to be at prices which could be breached if the stock traded at 11x cash earnings.

 

The $30 strike 2016 call requires more like 13x (in addition to $2 per share per year accrued between now and then).

 

So that's the reason why I jumped right to discussing the $30 strike 2016 -- just a valuation thing.  I don't want to get called out of the stock, but if the valuation is quite decent it would be a tolerable outcome.

 

[gary17]

Hi Eric

I want to pick your brain again about this artificial call you have setup with commons + puts...

 

Am I right to assume that you normally buy them at the same time?  i.e., let say you have 0 position today; and decided you want to initiate a position in BAC tomorrow - you would buy both the puts and the commons at the same time... almost immediately after each other.....  assuming this is right... then my question  is as follows.

 

i think the risk of this approach is if the price doesn't move much during the duration of the puts,... then you've paid the insurance for effective nothing... 

 

my question is this: can this risk be mitigated by buying the puts later when the commons have appreciated substantially, i.e., when the insurance policy is cheaper?

 

i suppose there's always the risk of the shares plummeting very soon after you bought the commons ... but if the market is generally not over priced, and the price of the commons is low.... the risk of the prices depreciating further is probably also low......  so by choosing an entry price that's low, that's the best thing one could do to address the risk.... buy cheap.  if you are already paying a low price, with a large margin of safety, and still buy the insurance, that is perhaps the source of adding to the risk of if the insurance policy expires worthless.  by purchasing the insurance when it's cheap, the consequence of not needing the insurance is mitigated... 

 

so it'd seems to make sense that if the investor has carefully chosen the entry price - that's cheap enough so that the risk is low.... it'd seem to make sense to hold off on buying the insurance later when the price has appreciated...   

 

--

 

last year i bought RIM at $7 and rode it to $17 -  it wouldn't have make sense for me to hedge when i bought it at $7 - but made a lot of sense for me to do so at prices over $10.... which i didn't do. 

 

Gary

 

 

 

 

[ERICOPOLY]

i think the risk of this approach is if the price doesn't move much during the duration of the puts,... then you've paid the insurance for effective nothing... 

 

I'm not worried about that.  It's also worth pointing out that 1/3 of the cost of these puts would otherwise go to taxes, so at least I'm getting something of value for that money which is otherwise taken from me.

 

[racemize]

I have 47 contracts of the BAC 2016 12's in my IRA.  My original plan was to hold these until BAC gets to the 19-20 range, or sometime close to 2015.  However, I'm beginning to worry that the 12's will be too deep in the money to be able to sell at that point (i.e., not enough volume).

 

Could one of you who is more experienced with options let me know if you think this will be an issue?  If it is, I guess I could wait until 2016 and exercise/sell (maybe, if the IRA let's you do that), but I'd rather just sell the contracts.  Maybe I need to roll just to keep the liquidity?

 

Thanks in advance!

[Uccmal]

Racemize, I have never noticed this being a problem.  I guess the way to check is to look at the trades of the 7.50 2015s and see if they are still moving.  Outside of tech stocks,  BAC options are among the most liquid.  I unloaded some $10 2015s last week in a few seconds.  The spreads were only a few cents.  I usually put my sell bid somewhere right of centre on the spread. 

 

 

[Straddle]

I have 47 contracts of the BAC 2016 12's in my IRA.  My original plan was to hold these until BAC gets to the 19-20 range, or sometime close to 2015.  However, I'm beginning to worry that the 12's will be too deep in the money to be able to sell at that point (i.e., not enough volume).

 

Could one of you who is more experienced with options let me know if you think this will be an issue?  If it is, I guess I could wait until 2016 and exercise/sell (maybe, if the IRA let's you do that), but I'd rather just sell the contracts.  Maybe I need to roll just to keep the liquidity?

 

No need to worry about that, liquidity is huge for BAC options (just like for other options on companies with that cap).

 

I once had liquidity problems with selling my long options on ETF's where the open interest was almost zero. I still could sell them, but I had to use market orders (limit orders were useless).

[racemize]

Thanks for your responses guys, I had just noticed that the BAC 10's had listed a volume of 10 last week, so then I was worried it was getting less and less liquid. 

[abitofvalue]

Thanks for your responses guys, I had just noticed that the BAC 10's had listed a volume of 10 last week, so then I was worried it was getting less and less liquid.

 

If you own them till expiry - why would you need to sell the options? Wouldn't they just cash-settle?  I don't know I am just asking. I though options typically cash-settle if they are in the money. Is this not right?

[Hielko]

No you either get the underlying or you have to provide the underlying (this is for US options anyway, might be different in other markets)

[ERICOPOLY]

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

[gary17]

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

 

This appears to suggest the market likes the long term prospect of BAC. Maybe better to buy commons ?

[ERICOPOLY]

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

 

This appears to suggest the market likes the long term prospect of BAC. Maybe better to buy commons ?

 

Is Mr. Market a wife beater?  Look at the chart of BAC stock price last month or two.  Just expressing love?

 

[gary17]

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

 

This appears to suggest the market likes the long term prospect of BAC. Maybe better to buy commons ?

 

Is Mr. Market a wife beater?  Look at the chart of BAC stock price last month or two.  Just expressing love?

 

You sound emotional! I find when there's hype and expectation not quite there the fall can be a bit harder.